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Zix Corporation (NASDAQ:ZIXI)

Q1 2014 Earnings Conference Call

April 22, 2014 5:00 PM ET

Executives

Geoff Bibby - VP, Corporate Marketing

Rick Spurr - Chairman and CEO

Mike English - CFO

Analysts

Mike Malouf - Craig-Hallum Capital Group

Michael Kim - Imperial Capital

Fred Ziegel - Topeka Capital Markets

Operator

Good day, ladies and gentlemen. And welcome to the First Quarter 2014 Zix Corporation Earnings Conference Call. My name is Regina and I’ll be your conference operator for today. At this time, all participants are in listen-only mode. Later, we will continue a question-and-answer session. (Operator Instructions) As a reminder, this event is being recorded for replay purposes.

I would now like to turn the conference over to your host for today Mr. Geoff Bibby, please go ahead.

Geoff Bibby

Thank you, Regina. As Regina mentioned, my name is Geoff Bibby, good afternoon. I’m Vice President of Corporate Marketing for Zix Corporation. Thank you for joining our 2014 Q1 call. You can find our earnings press release on our Investor Web site at investor.zixcorp.com. The earnings release contains instructions for accessing a recording of this call. Our Chairman and Chief Executive Officer, Rick Spurr will provide an overview of the Company’s performance in the quarter; then our CFO, Mike English, will give you details of all of our financial results. Later in the call, they will answer questions from analysts and institutional investors. Listeners can also submit questions during the call to our Investor Relations mailbox at invest@zixcorp.com.

Rick and Mike will provide forward-looking statements on matters such as forecast of revenues, earnings, operating margins and cash flow, projections about contracts or business and comments on trend information. The Company undertakes no obligation to publicly update or revise any forward-looking statements. Forward-looking statements are subject to risks that could cause actual results to differ materially from our expectations. The Risk Factors section of the Company’s most recent Form 10-K filing with the SEC gives examples of those risks.

Rick and Mike will refer to various non-GAAP financial measures such as adjusted gross profit, adjusted operating expenses, adjusted earnings and adjusted EBITDA. You can find in our earnings press release and on our Investor Web site, detailed explanations of our non-GAAP financial measures along with reconciliations of our adjusting items to the most directly comparable GAAP financial measures.

Now, I am pleased to turn the call over to Rick.

Rick Spurr

Thank you, Geoff. Good afternoon everyone and welcome. Pretty excited about the level of activity in the marketplace where we’re with respect to both our leadership in email encryption and with our new products ZixDLP and ZixOne.

Revenue for the first quarter was $12.2 million, up from $11.8 million in the same quarter last year. New first year orders for the first quarter were $2 million compared to $2.1 million in the prior year quarter. $2 million of new first year orders in Q1 was less than planned and is certainly not what we expect to achieve going forward. This result was due impart to the seasonal weakness we typically see in our business in the first quarter as newly budgeted projects for the year are often slow to begin ramping, particularly in large accounts.

In addition in the case of our enterprise sales group that sells to large accounts, we implemented Q1 reorganization, not only adding new sales people but also hiring a new Vice President of Enterprise Sales who started with us in early March. We believe this reorganization had a short-term negative impact on sales in our enterprise group where we experienced this shortfall. We also believe this poor showing by our enterprise group is a one quarter phenomenon. I’d like to remind everyone that last year, our enterprise group new first year orders were up 39%.

Our overall base email encryption business is very healthy. Our corporate group which typically represents around 60% of our business in fact was up 28% year-over-year, and OEM new first year orders which now represent only 13% of the total were essentially flat despite continued Google weakness. On our last call, we showed the fact that we were making significant increased investments in sales in 2014, but obviously it takes time for these new sales people to become productive.

Total orders during the first quarter were $12.5 million, compared with $13.9 million in the same quarter last year. Those of you who follow our order trending know that total orders tend to have peaks and valleys based primarily on the timing of renewals and impart on contract lengths. More specifically with regard to the timing of renewals, three year contracts that were signed last year are still in force and did not come up for renewal this year. Obviously the related revenue streams continue, but the longer term contracts signed last year for instance don’t create new orders for us this year. Our backlog which reflects all contractually committed business and therefore eliminates the impact of order timing was $65.9 million at quarter end which is up 11% over the same quarter last year.

On the bottom-line we achieved GAAP net income of $1.1 million or $0.02 per share on a fully diluted basis. Non-GAAP adjusted net income in the first quarter was $2.1 million or $0.03 per share on a fully diluted basis. During the first quarter, our business generated $1.7 million in cash flow from operations, up 61% over the same period last year.

I mentioned that our OEM business this quarter was essentially flat and represented 13% of our new first year orders. For all of last year, this OEM segment due primarily to the Google order slowdown associated with the transition to the new version of Google Message Encryption represented only 11% of our new sales. So, the Google transition is now no longer a drag on our new first year order results, but in fact represents an opportunity for accelerated growth in sales.

On the topic of the new Google apps message encryption service, where we are the technology provider. We continue to make progress but are still frustrated with the lack of an announcement. The technology is in place, support issues have been resolved. A new name has been chosen to prevent conflict with another Google service. SLAs or service level agreements have all been approved, but we’re still waiting for Google legal approval I am sorry of the language which will be used with their customers. With the exception of Google legal approval to our knowledge all issues have been resolved.

Although frustrated with the lack of a broad-based announcement, we are happy to report that together with Google we closed a deal in Q1 for use by the U.S. subsidiary of a large worldwide bank, representing nearly 15,000 users. We’re also happy to report another good quarter from our OEM relationship with Symantec. New first year orders from Symantec for the first quarter were up 36% from the prior year quarter and we expect to see continued growth over the course of this year.

As we typically do, I’ll now comment on sales contribution from an industry perspective. Our new first year orders in the first quarter broke down as follows; healthcare was 40%, followed by finance at 32%, other was 20% and government 8%. As most of you know other for us is a category that captures new first year orders from all non-healthcare, and non-finance and non-government accounts. As compared to industry contribution to new first year orders for all of 2013, healthcare contribution in Q1 was down around 6 percentage points, government was flat, finance was up 4 points and other was up 2 percentage points.

Now let me turn to an update on our new products, first I’ll comment on ZixDLP. ZixDLP our email data loss prevention solution is designed to help both new and existing ZixCorp customers address the number one data leakage problem in their organization, email. As of the end of March, we have 45 customers, while this is an increase of 20% over the number of customers we had at the end of December, we believe many prospective customers have been delaying their buying decision in anticipation of our new ZixDLP Version 1.1 which was introduced during the quarter and began shipping in early March.

To remind everyone, the major enhancement in version 1.1 is the ability to provide greater control, insight and visibility into the content of all outbound email and related attachments. Not just emails that are blocked and quarantine. So, the new functionality gives customers the ability to see exactly what triggered encryption in all outbound encrypted mail. This function is something customers have been asking about for many years to enable better understanding of what’s being released in their outbound email flow. This visibility also allows ZixDLP customers before they implement the policies to block certain emails to better understand and assess the data risks in their email and how the implementation of quarantine capabilities would impact their company’s workflow.

So version 1.1 was released in March and now we plan to launch ZixDLP version 1.2 later this month in April. This version 1.2 release includes tools that will enable the customer to delegate the decision regarding quarantined messages to the appropriate business unit. So instead of the IT or compliance department having responsibility for making decisions on the quarantine messages, an automated process will distribute the messages to the appropriate business unit for disposition. Both versions 1.1 and version 1.2 include the most frequently requested features from prospects and customers since we initially launched the product. We believe that once both of these enhanced versions are out in the market, we should see increased adoption.

Of the new DLP customers added during the quarter, three were large customers, representing more than 1,000 seats each. As a result of some of these larger installations at quarter end, the average number of seats for DLP was up over 400 in each account and the average price per seat was $8.75 which is moving closer to the average of $7 to $8 that we’ve guided to previously.

Now, I’d like to provide an update on ZixOne. Our new Bring-Your-Own-Device or BYOD solution that we launched last September. At the end of the first quarter, we had 68 new customers up from 45 at the end of the fourth quarter of last year. And the average number of seats was 50, up from 43 in the preceding quarter. The average price per user per year looking at all ZixOne customers at the end of the quarter was $51. As most of you know, this is a market and its adolescent stage and as such is experiencing some pricing pressure.

We intend to establish a meaningful market share and so as competitive prices come down we have brought our prices down accordingly. As a result, we now think that over the long-term our average price per user per year is likely to be around $21, the same as our email encryption business. These estimates assure many more large accounts with large numbers of users, as well as expansion within small and medium accounts all factors that will result in greater volume along with a lower price per seat.

We continue to be extremely excited about the potential for ZixOne and the market acceptance that we’re seeing. Earlier this month, we introduced ZixOne Version 1.9 our ninth release. This version includes some important functionality based on feedback from prospected customers. Some of who were ready to adopt the ZixOne solution but decided to delay until the new version became available with these additional features. These are features that many people have now become accustomed to in their day-to-day lives and include the ability to click to call a phone number contained in the body of an email, as well as to see a one-week calendar view. This one-week calendar view is now being offered in addition to the views we’ve had in the product since initial launch, including a daily calendar, a monthly calendar in a simple list, and the events calendar editing.

As we’ve noted before, the nimble design of ZixOne including the inherent instant on feature of the SaaS architecture enables us to add these enhancements and features very rapidly. While we’re still early in the market with ZixOne, we’re pleased with market acceptance and our pipeline of qualified leads continues grows nicely. To give some additional color, as of quarter end we had 19 evaluations underway in addition to the 68 contracted customers we mentioned. These represented signed evaluation contracts with prospective customers who rather had not committed to us or did not spent money and committed to install and test the product. Another noteworthy observation is that 21 of our 68 ZixOne customers are completely new to our Company, so we’re seeing prospective customers who are completely new to Zix determining that they had a need for BYOD and that Zix has a great solution.

To further underscore the market acceptance we’re seeing, I am pleased to note that we’re already seeing customers buy additional seats despite the fact that we just released the product this past September. Of our current ZixOne customers, several have already upgraded from their first contract level where they originally bought for a small number of users and then they came back willing to increase their deployment to a broader base of users.

In addition, with the positive traction we’re seeing with our increasing marketing efforts, the volume of marketing leads is at the highest level we’ve ever seen. These marketing leads include contact information for prospective customers who are in the buying process and we’re now reaching out to them to determine the quality of these leads and how many we can close.

In closing, we are very excited about our prospects for growth in our existing email encryption business and the increasing activity and growth opportunities we are seeing with our new products. The second quarter is typically a strong quarter for us and we see every indication that it will be strong again this year.

Now, I’ll turn the call over to Mike English, our CFO to discuss our first quarter financial results in more detail and after that we’ll take questions. Mike?

Mike English

Thanks, Rick. Good afternoon everyone. As I typically do, I will begin with our GAAP revenue and earning results and then move to our non-GAAP metrics and conclude with the second quarter and full year 2014 outlook. As a reminder, the non-GAAP measures exclude stock-based compensation, non-cash tax expense or benefit and if applicable any other non-recurring expenses. As mentioned at the start of the call, we include a reconciliation of our non-GAAP measures with our financial statements in our earnings press release. This reconciliation is also available in the Investors section of our Web site.

Beginning with our GAAP results, first quarter revenue was $12.2 million, up 3% year-over-year. The first quarter was impacted by Google delays and what believe to be timing of new orders in our enterprise sales group. However, much of this impact was offset by scheduled revenue from normal backlog amortization which we expect from our subscription model and good first quarter renewal rates.

Net income for the first quarter was $1.1 million or $0.02 per fully diluted share, up $0.01 compared to the prior year. Gross profit of $10.1 million improved $300,000 compared to the prior year and on a percentage basis remained flat at 83%. Sales and marketing expenses were up $607,000 compared to the same period last year and GAAP federal income tax expense was up $556,000, both in line with the expected increases in these areas. Despite these higher expenses, net income improved almost 90% due to higher gross profit and lower legal fees.

Moving on now to our non-GAAP metrics. For the first quarter of 2014, adjusted net income was $2.1 million or $0.03 per fully diluted share, down less than 1% compared to the prior year despite increases in sales and marketing which were up 17% on an adjusted basis. Adjusted gross profit was $10.2 million, up 3% compared to the same period last year. This represented an 84% gross margin.

Total adjusted operating income was $2.2 million, up slightly compared to the same period last year. While sales and marketing was up 17%, the other components of adjusted operating expense, cost of sales, R&D and G&A were down a combined 4% year-over-year, due to relatively minor increases in cost of sales and G&A which were more than offset by lower R&D expense. The lower adjusted R&D expense resulted primarily from a reduction in a number of R&D contractors and savings associated with converting some contractors to employees.

First quarter 2014 adjusted EBITDA was up 3% to $2.6 million or 22% of revenue. This compares to $2.5 million also 22% of revenue for the same period last year. Ending backlog was $65.9 million, up 11% compared to the prior year. This increase resulted from new orders as well as strong renewals and benefited from multiyear contracts. As discussed in the past, we continue to encourage contract terms of three or more years which contribute to the backlog growth and solidify our future scheduled revenue. We expect to recognize 55% of the Q1 ending backlog into revenue in the next 12 months, this compares to 56% of the Q1 ending backlog at this time last year.

During the quarter, we generated $1.7 million cash from operations and used $391,000 to purchase capital equipment mostly computer and networking equipment. We also used $6.2 million in the quarter to purchase our stock, completing a $15 million repurchase plan announced in November of last year. Under this plan the Company repurchased a total of 3.4 million shares of our common stock at an average price of $4.43 during the period November, 2013 through March, 2014. Ending cash balance at March 31, 2014 was $22.5 million.

A quick update on our cash flow. During 2014 we expect to make improvements to our leased office facilities in Dallas, designed to accommodate our headcount expansion. We expect improvements to total approximately a $1 million, most of which will be reimbursed by the building landlord as part of a lease renewal incentive allowance.

Consistent with accounting guidance we will record future cash disbursements for these leasehold improvements as purchases of property and equipment in the investing section of our statement of cash flows. The cash received from reimbursements will be recorded in the operating activities section of the statement of cash flows. We expect to begin these improvements in the second quarter of this year and complete most of the renovations by year-end.

Before moving onto the outlook, I want to provide an update on our Federal income taxes. Q1 of this year was the first quarter for us to record a full GAAP Federal income tax provision. The tax provision was $650,000 and of this amount 536,000 was non-cash tax expense. As I’ve stated in the past, we have a large deferred tax asset which is used to offset Federal income tax liability, so our cash taxes remain low even though we continue to be profitable. These non-cash taxes are excluded from non-GAAP net income.

Beginning in 2011 and continuing in each year to 2013, we reported GAAP tax benefits on our income statements as we reduced our fully provisioned deferred tax asset valuation allowance consistent with accounting rules. Beginning in 2014 we are at or near the GAAP prescribed balance in the allowance and determined that no further adjustment was necessary. Therefore for the first quarter of 2014 we recognized the full Federal income tax provision. We still have a substantial allowance, so going forward we will determine on a quarterly basis if future reductions to the allowance are necessary.

Turning now to our revenue and adjusted EPS outlook for the second quarter. We expect Q2 2014 revenue of $12.3 million to $12.6 million. This revenue guidance is expected to generate Q2 adjusted earnings per fully diluted share of $0.02 to $0.03. For the full year, the Company’s previously issued revenue guidance of $53 million to $55 million and adjusted earnings per fully diluted share of $0.15 to $0.17 remains unchanged.

With that, I’ll turn the call over to Rick

Rick Spurr

Thank you, Michael. And with that, let’s go to the listeners to see if there’s any questions.

Question-and-Answer Session

Operator

(Operator Instructions) And gentlemen, your first question today comes from the line of Mike Malouf of Craig-Hallum Capital Group.

Mike Malouf - Craig-Hallum Capital Group

Great. Thanks guys for taking my questions.

Geoff Bibby

Sure Mike.

Rick Spurr

Hi Mike.

Mike Malouf - Craig-Hallum Capital Group

Just a couple of things, one on ZixOne, you said that the activity is as high as it’s ever been. And I’m wondering if you could just give us some real time snapshot on how your investments are having at least an early effect? And maybe if it’s too early, then you can sort of just walk us through how these investments will impact the sales and really where the focus is? Some color on that would be helpful.

Rick Spurr

Sure. So the activity that we referenced, specifically that I think was as high as you’ve ever seen, was around marketing leads. So as you would expect, we ramped up our marketing investments and our activity in the marketplace today with a whole variety of outreach through, in some cases, well known third-parties, CIO magazine, Gartner, webinars with people that draw our clients and prospects to the story, and out of that we get leads. So these are people who showed interest and in many cases had asked for someone to contact them. So that measure of early activity is what’s showing up now as you would expect and which gives us confidence about our ability to close some of these.

Mike Malouf - Craig-Hallum Capital Group

Okay, great. And then with regards to the guidance, 53 million to 55 million, what is included in that guidance with regards to Google?

Mike English

Mike, I am not going, this is Mike English, I am not going to get into the specifics of what’s included or not included. It is, we have to make decisions about that range, so I am sorry I am not going to be able to tell you exactly what we’re doing with Google, but as we said we still are unsure about the timing of when they are going to comeback. So, that has a big part in the range that exists, the 53 to 55.

Mike Malouf - Craig-Hallum Capital Group

So, Google doesn’t come back this year, that’s more at the lower end and if Google comes back we’re at the higher end, is that the way to read it?

Mike English

I can’t say specifically but sure absolutely if Google did not come back, it would certainly put pressure on the high-end that’s right.

Mike Malouf - Craig-Hallum Capital Group

Yes, yes okay, alright, good. And then just for one follow-up, can you give me those breakdown of the enterprise, corporate and OEM numbers again?

Mike English

Yes, so we gave you an update and you can piece it together, so our new first year orders were 2 million, OEM was 14% if my memory serves me and the corporate was around two-thirds of that number, so the S&B and all of buyers and third-party channels represented about two-thirds and the balance was enterprise.

Mike Malouf - Craig-Hallum Capital Group

Balance was enterprise, so if I do the math on that one order that you got from Google, 15,000 users and if you even use the $20 and maybe that’s just too high that would be 300,000 so that wouldn’t move anything for Symantec. So…

Mike English

Yes, your assumption on pricing is too high, so when we get, our pricing through Google is $15 to $21 per user per year based on volume. But when we get into the 10,000 plus that’s a negotiated price and those are often times below that range and are in this case.

Mike Malouf - Craig-Hallum Capital Group

Got it. Thanks a lot for the help.

Mike English

Sure. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Michael Kim with Imperial Capital.

Michael Kim - Imperial Capital

Good evening guys.

Mike English

Hey Mike.

Michael Kim - Imperial Capital

So, Rick, just turning to the ZixOne product and the pricing environment for mobile, I think in your prepared remarks you talked about $21 per user per year. Can you give us some visibility on how that was constructed and your sense on how that might change overtime?

Rick Spurr

So today we said Mike it’s our pricing for the users we have is $51 per user per year. And we published some new pricing, actually just to our sales force here in the last few days and some of which just slip into this will go public on our Web site. But we probably set pricing around what we’re seeing competition do, Good, AirWatch, MobileIron all of whom have come down from the time we first announced this product back in the fall to just we are of some short seven months later. So, then we take our new pricing and we lay into our current distribution of customers across very large enterprises as well as small and medium business and just do the math on a spreadsheet and say look, if we’re successful with this product and we get a similar distribution as we have in our credit base email encryption business, what would that tell us about the average per user per year price and that backed to almost 21 bucks.

Michael Kim - Imperial Capital

Okay. So, that’s presumed to a similar base in paid users as email encryption?

Rick Spurr

Correct.

Michael Kim - Imperial Capital

Okay. And then in the evals that are underway…

Rick Spurr

Now Mike, let me just be clear here, that’s not because that’s how we think of the opportunity, I think the opportunity for ZixOne is across a much larger base of users on an absolute basis. But if you are trying to do some planning about average pricing, you need some sort of distribution assumption and I use that assumption.

Michael Kim - Imperial Capital

Yes, understood. Fair enough. And then just in the evals that are underway at the moment and some of the, even some of the early customers, are any of them, would you characterize any of them as fairly large scale enterprises and with those, a number of those convert to enterprise-wide deployments this year or essentially drive that function in the paid user base for ZixOne?

Rick Spurr

Yes, we’re not going to get into the granularity of how big the various customers are and breakout the evals and all that but yes there are enterprise customers both in terms of evaluating the product as well as having bought the product. I can’t predict when they might choose to expand but I can say that we’re very excited about the look and feel of the product. And when you realize how fast it is and how easy to use it is, we think it’s going to be something that people are going to see, they are going to show their friends and it is going to have some expansion, hard to predict right now, many.

Michael Kim - Imperial Capital

Okay. And then lastly on the enterprise sales group, do you have visibility on that the changes that you’ve implemented in the new leadership that the impact is isolated to a quarter, is it likely that it might extend another quarter beyond the second half?

Rick Spurr

Yes, I actually said in the script that we believe this to be a one quarter phenomenon. There is nothing about the current quarter we’re in and the forecast I’m looking at and the pipeline I’m looking at and the activity that would suggest that that weakness will continue. So we feel good about where we are going forward.

Michael Kim - Imperial Capital

Got you. Great. thank you very much.

Rick Spurr

Thank you.

Operator

Your next question is from the line of Fred Ziegel with Topeka Capital Markets.

Fred Ziegel - Topeka Capital Markets

Hi, guys. Just to follow on to that. So exactly what is the sales issue you’re trying to correct and secondly well let’s start with that.

Rick Spurr

And I’m sorry Fred, when you say trying to, so there is two things going on, one is, it’s just a greater investment in sales resource which is about greater coverage, and so that’s not really a correction that’s just an expansion. And then the new Vice President of Enterprise Sales is just about getting the right person in the job, so he fits with the culture and the spirit and has the talent and experience that match to what it is we’re doing in the marketplace.

Fred Ziegel - Topeka Capital Markets

So are we trying to drive more business through Zix direct channels as opposed to the partners?

Rick Spurr

No, so what we’re trying to do is get a greater contribution from the enterprise sales group that we think the maturity of that product and the sophistication of our product competes well in the high-end. We have some very sophisticated customers today. And we think we ought to be getting more of that and winning more business there. The other components of the business certainly the corporate S&B spaces running in high gear and we’re pleased and continue to invest and expand there. And the OEM business is about turning the Google faucet back on and continuing to grow Symantec opportunity. So this is just looking at every part of the business where we can get improvement, we think there is opportunity to improve in their current sales.

Fred Ziegel - Topeka Capital Markets

You said that Symantec is distracted with all their internal issues and secondly why is Google on the gaze?

Rick Spurr

Yes, we pretty much said as much as I can say about Google I told you all the issues we resolved and that they have legal language that they had crafted and it’s been approved at some levels to be included in their customer contracts which will communicate to their customers that there is third-party content in the Google apps branded capability that we’re offering.

In the case of Symantec, yes sure they’re distracted. I mean they’re on their on an Interim CEO that must have been the third CEO as many years, so it’s not as if we’re in continuing communication with them and that in trenches we’re still having progress and success. So it’s not like the train has stopped, but I wouldn’t tell you that the world is the same as they swap out CEOs either.

Fred Ziegel - Topeka Capital Markets

Yes, last question. What are you seeing in terms of any interest building for encryption vis-à-vis the MSA and often higher value in all things?

Rick Spurr

Yes, the whole I’ll call it post noting MSA era that we’re in, I think it has better educated everyone about number one, the need for encryption and in many cases just what it is and how it works and all that’s good for us. It hasn’t resulted in the phones ringing off the hook for more individual users that have impacted us in any meaningful way. But overall when the awareness goes up you’ll expect that you’ll get over the longer term broader based adoption and of course that’s good for us.

Fred Ziegel - Topeka Capital Markets

Okay, thanks.

Rick Spurr

Thank you.

Operator

Ladies and gentlemen, this concludes the question-and-answer portion of today’s event. I’d like to turn the call back over to Mr. Spurr for any closing remarks he’d like to make.

Rick Spurr

We got work to do, we’re going to go solve things and we’re excited to be able to deliver these messages today and we look forward to our next call with everyone. Thanks for your interests.

Operator

Ladies and gentlemen, this concludes the presentation and you may now disconnect. Have a great day.

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