Interactive Intelligence Group's (ININ) CEO Donald Brown on Q1 2014 Results - Earnings Call Transcript

Interactive Intelligence Group, Inc. (NASDAQ:ININ)

Q1 2014 Earnings Conference Call

May 5, 2014 4:30 PM ET

Executives

Stephen R. Head - Chief Financial Officer, Senior Vice President, Finance and Administration, Secretary and Treasurer

Donald E. Brown - Chairman, President and Chief Executive Officer

Analysts

Shyam V. Patil – Wedbush Securities, Inc.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Raghavan Sarathy – Dougherty & Co. LLC

Mike Latimore – Northland Securities, Inc.

Craig Nankervis – First Analysis Securities Corp.

Josh M. Goldberg – G2 Investment Partners Management LLC

George Prince – RBC Global Asset Management Inc.

Operator

Good day, ladies and gentlemen, and welcome to the Interactive Intelligence First Quarter Earnings Conference Call. At this time all participants are in a listen-only mode, later we’ll have a question-and-answer session and instructions will be given at that time. (Operator Instructions) As a reminder, this call is being recorded.

I’d now like to turn the call over to Mr. Steve Head, CFO. Sir, the floor is yours.

Stephen R. Head

Thank you, good afternoon and thank you for joining us today to review Interactive Intelligence's first quarter 2014 financial results. With me on the call today is Don Brown, our Chairman of the Board, President, and CEO. Don will begin with a high-level review of our first quarter performance, in addition to providing an update on our key initiatives. I will then review our first quarter financial results in more detail and provide financial outlook before turning it back to Don for closing remarks. We’ll then open the call for questions.

Please note that over the course of this conference call, we will make predictive statements about our results, performance, plans, and objectives in an effort to assist you in understanding our company. The enterprise software industry, combined with the rapidly evolving uncertainties and the economic environment, make predictions challenging and problematic. These predictive statements are forward-looking statements under Federal Securities laws.

Our actual results could differ materially from the information presented during this call, and you should review the section on forward-looking statements contained in today's earnings release as well as our 2013 Form 10-K and other public filings with the SEC, which describes factors, risks, and uncertainties that could cause our actual results to differ materially. The Company disclaims any obligation or undertaking to update or revise any forward-looking statement.

Also during this call, we will refer to non-GAAP financial measures. These non-GAAP results eliminate the impact of noncash stock-based compensation expense, purchase accounting related adjustments, and include pro forma tax expense. Management uses these non-GAAP financial measures in analyzing the business.

With that, I'll turn the call over to Don.

Donald E. Brown

Thanks, Steve, and thanks to everybody for joining us on the call today to review our results for the quarter. We are very pleased with our execution during the quarter as our overall level of business activity remained high, and our global pipeline continues to increase.

Our strong start to the year highlights the leverage we continue to see from investments in product development, sales and marketing, and operations including customer service. We believe that Interactive Intelligence remains in position to extend its product leadership position and build on the strong momentum it has in the cloud market, which continues to be the highest growth segment of our market.

During the first quarter, cloud-based orders increased 165% year-over-year and accounted for 59% of total orders, up from 31% during the same period last year. In addition, cloud-based revenues increased 85% year-over-year and accounted for 30% of recurring revenues, up from 21% in the first quarter of last year. We are very pleased with the rapid growth in our cloud revenues since it continues to have a positive impact on the increase in scale of our overall recurring revenue and the visibility of our business.

As a result, we expect recurring revenues, which includes both maintenance contracts and cloud-based revenues to represent approximately 50% of total revenues in 2014, up from 46% last year; and for our cloud-based orders to account for 55% to 60% of total orders, which compares to 50% last year and 35% in 2012.

In addition, given the strength of our growing pipeline of opportunities around the world, we continue to expect 2014 total order growth of at least 20%. Taking a look at some of the summary level statistics and financials for the quarter, total orders increased 42% year-over-year with cloud-based orders representing approximately 59% of the total.

We won 54 new customers during the quarter compared to 74% in the year-ago quarter. While the number of new customers was down, the average dollar amount of new cloud and premises based customer orders was up $935,000 and $516,000 respectively in the first quarter of this year compared to $788,000 and $335,000 during the same period last year.

We had nine orders that were over $1 million; this compares to 8 in the year-ago quarter. And we had an additional 25 orders that were between $0.25 million and $1 million compared to 31 in the first quarter of last year.

Our first quarter revenues were $79.4 million, up 8% over last year and in line with the outlook we stated in February. Non-GAAP operating loss for the first quarter was $1.0 million, which was below our guidance of breakeven and the direct result of increased cloud orders with deferral of revenues to future periods.

As we’ve mentioned in the past, it only takes a handful of orders to change the mix of that ratio of premises versus cloud. The ongoing growth in our cloud-related business continues to result in revenues being deferred to future quarters, which contributed to the overall growth of our unbilled future cloud revenue.

During the first quarter, our overall deferred revenue in unbilled contracts increased 56% on a year-over-year basis to $321 million. As we continue to execute on our strategy to improve the long-term financial profile of the Company, recurring revenue for the first quarter which includes both maintenance contracts and cloud-based revenues, increased 28% year-over-year and was primarily driven by the 85% growth in cloud-based revenues. As a result, recurring revenue increased to 55% of total revenues in Q1, up from 46% during the same period last year.

From a geographic perspective, we saw top solid customer demand in orders across 0074he Americas, Europe, and Australia. Only Latin America and Japan came in under our expectations during the quarter. As we’ve stated in the past, we’ve seen similar quarter-to-quarter fluctuations in the past and expect to see growth overall in all regions in 2014. What is most meaningful from our standpoint are the long-term trends and the pace of pipeline activity, which continue to be strong.

From an industry perspective, we continue to be the only vendor with the proven scalability, reliability, and functionality in a cloud-based contact center offering, and we believe that it remains very important for us to maintain and extend this advantage. Our 165% increase in cloud orders is evidence that Interactive Intelligence is extending its leading position and becoming the vendor of choice among large enterprises looking to benefit from the advantages of a cloud-based solution.

As a result, we’re continuing to invest in product development and sales and marketing globally, especially given the strong pipeline of opportunities I mentioned earlier. We also remain very excited about our next-generation effort that leverages modern open source technologies in the Amazon Web Services as the deployment back end. This will give us a multi-tenant solution that is super easy to deploy and capable of handling the needs of both very large and very small customers, and it will do all this at our much lower operating cost.

This solution will allow us to enter the growing market for cloud-based unified communications as well as provide another option for contact center automation. As a reminder, our fiscal 2014 guidance does not include any revenue generation from this offering, although it does reflect the ongoing investments we're making in the platform.

And we are very excited about our announced acquisition of OrgSpan, which is bringing a new set of foundational components to Interactive Intelligence that will be used in our new multi-tenant offering as well as our current CaaS offering. We have already incorporated the technology into our platform and the acquisition will streamline development and give us the benefit of OrgSpan’s numerous patent filings.

As a reminder, OrgSpan helps connect employees within large organizations and also provide technologies to allow customers to search and view agent profiles creating new and more effective ways of connecting customers and contact center agents. We believe that the acquisition further solidifies our leading position in the contact center market and gives us a team of roughly 30 very strong developers to add to our existing team.

We are looking forward to hosting our annual global customer and partner conference, INTERACTIONS 2014, which is being held June 2 to 5 here in Indianapolis. We anticipate an audience of more than 2,000 total attendees comprised of customers, prospects, partners, consultants, analysts, and media. The conference will include more than 160 sessions covering a full range of communications and customer service topics, including several new panel discussions that will give attendees unique insight into the next generation of customer service. As part of the conference, we plan to host an Investor Day on the afternoon of June 3, which will be webcasted.

So in summary, we are very pleased with our execution during the first quarter, and as we look ahead, we entered the second quarter with good momentum and believe the Company remains well positioned to continue gaining market share and increasing the portion of business devoted to a recurring revenue model, primarily due to the rapid growth of our cloud business.

So with that, let me turn the call over to Steve.

Steve R. Head

Thanks, Don. I will first provide more details on the Company’s first quarter financial results and then conclude by providing our financial guidance for the second quarter and full-year.

Beginning with the P&L, as Don mentioned, we reported revenues of $79.4 million, up 8% compared to the first quarter of last year and in line with our guidance. Our revenues during the first quarter reflect the growing portion of orders that relate to our cloud-based offering, which were recognized over the life of the contract.

The primary driver to our total revenue growth continued to be our recurring revenue sources, which include maintenance and subscriptions and totaled $43.4 million during the quarter and were 55% of total revenue. The growth in recurring revenues was driven by the rapid growth of our subscription revenues, which increased 85% year-over-year and 24% quarter-over-quarter to $13.1 million, along with the increases in maintenance and support resulting from the increasing installed base of premise customers.

During the first quarter, our subscription revenues did benefit from higher seasonal usage from a large customer, which we don’t expect to recur during the second quarter. As a result, we anticipate subscription revenues to slightly decline in Q2 compared to Q1, but still show strong growth on a year-over-year basis of 70% to 75%.

Non-GAAP product revenues totaled $22.8 million, representing 29% of revenue and declined 18% on a year-over-year basis, primarily due to the stronger mix of cloud-based orders during the first quarter. As we have mentioned, it only takes a handful of orders to change the mix of premises versus cloud.

We continue to expect to see a level of quarterly variability in both the growth and mix of our revenues going forward. While we continue to expect on-premise orders in 2014 to be comparable to 2013 for the full year, these orders were down 14% on the first quarter and contributed to the lower product revenues recognized compared to the prior year.

We received an increased dollar amount of orders from both new customers and from existing customers during the quarter as the average new customer order increased 54% to $516,000 in the first quarter of 2014 from $335,000 in the first quarter of last year.

Services revenues were $13.2 million during the quarter, an increase of 16% year-over-year, but down 9% compared to the fourth quarter of 2013. The quarter-over-quarter decline is primarily due to the decrease in professional services revenues from large direct customer engagements.

In addition, professional service revenues associated with our cloud-based deployments are generally lower than premise-based deployment and a stronger mix towards cloud in the past several quarters also contributed to the sequential decrease.

During the first quarter, our partners generated 50% of total orders compared to 41% in the first quarter of last year. This increase was primarily due to greater partner involvement in cloud orders.

Geographically for the quarter, the Americas provided 79% of total orders while EMEA was 14% and Asia Pacific was 7%. Non-GAAP gross margin was 60.2% in the first quarter compared to 65.3% during the same period last year. Non-GAAP product revenue gross margin for the first quarter was 70.3% in 2014 compared to 71.9% in the first quarter of 2013.

The product margin in any quarter is based on the hardware and software that is recognized as revenue in that quarter and will vary. Non-GAAP recurring revenue gross margin for the first quarter was 66.8% compared to 71.2% last year. The year-over-year decline was due to our cloud growth and the lower current margins on our cloud operations. Non-GAAP services revenue margin was sub-21.1% compared to 31.6% last year. As we have discussed in the past, we did not believe that the 30% margins were sustainable and we needed to add staffing to meet demand.

Non-GAAP operating loss, which excludes stock-based compensation expense and purchase accounting adjustments was $1 million in the first quarter, slightly below our expectations due to the stronger 59% mix of cloud-based orders during the quarter.

Non-GAAP net loss for the first quarter was $400,000 or $0.02 per share based on 20.7 million shares outstanding compared to net income of $3.6 million or $0.17 per diluted share for the first quarter last year.

To illustrate how the mix can affect reported earnings with the same dollar amount of orders, but only 55% of cloud, we would have reported revenue increase of approximately 11% and non-GAAP operating results just below breakeven for the quarter. And if we have the same dollar amount of orders but only 31% cloud as we did in the first quarter a year ago, then we would have reported revenue increase of approximately 28% with an 8% operating margin.

So, clearly, the mix shift is having a dramatic impact in both recognized revenues and reported operating results. Providing summary level results on a GAAP basis during the first quarter, GAAP operating loss was $4.8 million and GAAP net loss was $2.6 million or $0.12 per share. This compares to GAAP operating income of $3.4 million and GAAP net income of $1.5 million or $0.07 per diluted share in the first quarter of last year.

Turning to the balance sheet; as of March 31, we had $104.9 million of cash and investments which compares to $107.8 million as of December 31. The decrease in cash during the first quarter is the result of generating $5.3 million in cash flow from operations, offset by $8.1 million used for capital expenditure. Now, the company continues to be debt-free.

Accounts receivable outstanding at March 31, 2014, accounts receivable days sales outstanding were 80 days compared to 97 days last year and 80 days at the end of the fourth quarter of 2013.

Adjusted DSOs which take into account the increase in deferred revenues were 81 days. Total deferred revenues at March 31, 2014, were $115.5 million, an increase from $110.2 million as of a year ago. As we continue to sign additional cloud-based contracts, we’ve built an amount of contracted future revenue that is not recoded. This amount totaled $205.5 million as of March 31, 2014, up from $95.8 million as of march 31, 2013. Deferred revenues on subscriptions totaled $321 million as of March 31, 2014, which is up 56% from the $206 million one year earlier.

Before I discuss our financial outlook I wanted to provide some additional details on the announced acquisition of OrgSpan. Under the terms of the agreement, we have agreed to a purchase price which includes both stock and cash paid upon closing. The impact on revenues is not expected to be material for this year, but we are adding development expense at a faster pace than we had originally anticipated. This will cause some additional expense versus our initial plans for the year, but that additional expense is less than 1% of expected revenues.

Turning to our financial outlook for the year starting with the second quarter, we’re targeting second quarter 2014 revenues in the range of $86 million to $88 million, a growth of 13% to 15% and a breakeven operating margin for the second quarter.

As a reminder, given it only takes a handful of orders to change the mix, we could expect to see a level of volatility in both the growth and mix of revenues as evidenced by our Q1 results.

As we have discussed in the past, there is a short-term impact of cloud orders because we do not recognize the revenue upfront, resulting in lower near-term profitability, but that has a positive result leading to growth of recurring revenues longer term. For the full year, we are reaffirming our overall growth target of at least 20% in orders. While we exceeded that rate in the first quarter, we are still at the beginning part of the year in addition to more difficult comps for the second quarter.

We are also maintaining our total revenue guidance of $365 million to $370 million or an increase of about 15%, and non-GAAP operating margin of 1% to 3% resulting in non-GAAP EPS of $0.15 to $0.36 based on 22.5 million diluted shares.

As we saw in the first quarter, the shift to cloud does affect quarterly reported results. Further, professional services tend to be less in comparison to order amounts for cloud, so as cloud becomes a larger portion of orders, we could see some impact to professional services revenues.

Even though increased cloud orders pushed revenue out to future quarters, we believe that is a good thing for our business and our shareholders as it further cements our leadership in the overall market for cloud communication services and positions us for increased profitability in the future. We anticipate continued positive operating cash flow on an annual basis.

So now let me turn the call back to Don for some closing thoughts.

Donald E. Brown

Well, we continue to be very pleased with the momentum of our business given the growing pipeline of global opportunities, which is our main objective, and we continue to focus on increasing orders as rapidly as we can, especially in the cloud. We feel that our next-generation solution which we expect to introduce next month has the potential to be truly disruptive, allowing us to address even larger market and put our competitors at an even bigger disadvantage.

Furthermore, we feel that we are now in a position to realize additional operating efficiencies that will allow us to increase the profitability of our cloud operations in 2015 and beyond.

So with that I’ll turn the call back over to the operator for questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Shyam Patil with Wedbush Securities. Your line is now open. Please proceed with your question.

Shyam V. Patil – Wedbush Securities, Inc.

Hi, thank you. Just first question, when I look at the order, it growth seems very strong overall, especially for – as well as the cloud, how does that compare to your expectations for the quarter, I know you don’t guide typically ahead of the quarter, but how does that compare to your expectations, Don or Steve?

Donald E. Brown

Yes, it was in line with what we were looking for. As I said, we are mainly focused on the growth for the year. Our goal over the last several years has been to grow orders by 20% or more every year, and that’s what we are after, so we don’t get too hung up on quarter-to-quarter numbers, but certainly that was in line with what we were looking for, and I think the sort of numbers that we put up, the overall order growth and especially the cloud order growth is something that we are pretty happy with.

Shyam V. Patil – Wedbush Securities, Inc.

And Don, you mentioned, is it the large deal pipeline in your prepared remarks. I am wondering if you could maybe talk about how your pipeline looks in terms of the mega deals, if you will. I think over the past couple of years, you’ve been able to do one or two a year. What are your thoughts on kind of that portion of the pipeline and kind of your expectations for this year?

Donald E. Brown

Well, it continues to grow. Of course, by their very nature, those mega deals are very difficult to project into a particular quarter, so it makes our business lumpier than we would like. So, that part of our business, we think is very much on track. One of our objectives for this year, that will take a while has been to hire additional sales people and do more in the mid-market what for us would be smaller deals, $100,000 to $0.25 million or so. So, we really want to see that part of our business grow so that we reduce the overall lumpiness and we increase the overall penetration of our brand.

But in terms of the big deals, we continue to be pulled into some of the biggest companies and the organizations around the world, and that is proving to be even more the case with the next-generation offering that we’ll be unveiling next month.

Stephen R. Head

And just to follow-up on that Shyam, if you’re looking at the average order sizes, clearly there were a lot of deals that were just not $1 million or $2 million, they may not have been mega deals, but they were more than $1 million or $2 million size. There were several deals that were very nice sized during the quarter.

Shyam V. Patil – Wedbush Securities, Inc.

Yes, that’s helpful. It is my last question, could you talk a little bit about your Global Alliance program, just your strategy there, and maybe what you are hoping to accomplish with that? Thank you.

Donald E. Brown

Sure. Well, as we get pulled into larger deals, we are looking for partners to help us fulfill those deals, so Global Alliance’s focus is partly on partnerships that are focused on service delivery, consulting, and those sorts of things especially with these Global 500 sort of companies. We are talking to distribution partners as well who operate on a larger scale than we’ve traditionally been involved with.

And then the third element of Global Alliances is really the interconnection of our software and services with many other vendors out there, and so those guys are busy building connectors to allow our software to inter-operate with these third-party solutions in a way that adds value for our customers.

Shyam V. Patil – Wedbush Securities, Inc.

Perfect, thank you.

Operator

Thank you. Our next question comes from the line of Jeff Van Rhee with Craig-Hallum. Your line is now open. Please proceed with your question.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Great thank you. A number of questions. First, just can you go back and clarify on the -- Steve, I think you touched on the usage pattern at the subscription customer that’s going to lead to the sequential decline. Can you just expand on that a little bit further, this specific customer, what kind of drag is, and can you tell us a little more about sort of the usage pattern that drives that magnitude and then also maybe put it into context of other similar context just to get a better sense of sort of the overall sensitivity of that line to usage?

Donald E. Brown

It’s one particular customer that under the terms of the agreement and based on the business model, they have a lot of usage during March and April. And so, we expect we’ll get a little carryover for the first part of April, but the billings for that customer are fairly significant and that will be down for the second quarter, and a result, subscription revenues overall will be fairly flat for the second quarter versus the first.

Overall business, obviously underlying it is continuing to grow and will be up, as I mentioned, 70% -- expected to be up 70% to 75% compared to a year-ago. It’s just going to look relatively flat because of that usage pattern.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Are there others in there that are large enough or have usage habits or contract structures such that we should expect this over time that we’ll see from time-to-time quarterly declines based on usage? Is this going to be a regular occurrence, sort of an unusual, anything you can do to help there?

Donald E. Brown

I think it’s unusual and as we are adding more customers, in a year from now, we’ll have more customers and this customers’ pattern may be less noticeable. We’ll just have to see where we are by then, but I don’t think it’s going to be something that we see more and more customers having that sort of pattern at least with the customers we have been signing so far.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Okay, and then I guess just for both of you as it relates to the deal size ramp, which has just been really impressive. Can you just expand on that a bit? To what degree are we taking the same size customer, amd just selling in a lot more product because you expanded your product set versus moving up market and just selling the larger customers, I’m sure there is some of both, but can you just help us with both the ARPU increase thus far, how you would size it among those? And then just thoughts on sort of how close we are to a ceiling if there is one?

Stephen R. Head

Yes, I think certainly a contributing factor is the success of our process automation product, IPA, so we do have some more stuff to sell, but without seeing any sort of quantitative analysis, I can tell you my gut feel is that we are primarily being pulled into larger organizations, larger deals, companies who are looking at our solution in a way -- who are looking at our solution at all who two, three years ago wouldn’t have been because they wouldn’t have perceived that our solution was a fit.

I think we’ve done a tremendous job in the last two or three years in dispelling any notion that we can’t scale to handle large companies, and because of the success that we’ve enjoyed, we continue to get pulled into ever larger ones, and there’s still ways to go on that trajectory. There is still very large deals that have primarily been the province of – just two or three of our largest competitors, and now we are being invited to those dances, and when we do receive that invitation, we tend to perform pretty well.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Got it. Okay, and then last for me then, just on the CapEx front, I guess can you just revisit on the trailing year, even current quarter, where the CapEx spend is going, and just give us a context going forward how to think about those numbers, maybe as absolute dollars, is the way to think about it given the mix is hard to do a percentage, but some way to think about CapEx here and going forward both what you are doing and what you intend to do, and then in the light of broader usage of AWS and its implications for less CapEx? Just help us how to think about that.

Donald E. Brown

Sure Jeff, so as I mentioned for the quarter, it was about $8 million. Half of that was for data center infrastructure building at Montreal and some other sites. For the year Ray, it’s actually going up a little bit more for two reasons. Hiring is continuing at a very fast pace, and so furniture and equipment and other things, but we will have some more data center equipment. We just announced last week that we’re building a new office building and there will be some out-of-pocket related to that, that haven’t originally been factored into the budget.

So right now for the year, my expectation is capital expenditure of probably $22 million to $24 million. About $8 million of that will be a data center. The rest is really related to office leaseholder improvements and furniture and computers, internal IT types of equipment, so it’s spread all around.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

And I guess just around that out then, just intentions going forward, I mean are we going to continue to see -- is there a plateau where that levels off in absolute dollars, and then also just how to think about CapEx? Is AWS going to have a materially positive impact in terms of less necessary CapEx?

Donald E. Brown

Yes. Obviously as we continue to add employees, we are going to continue to add offices and have those CapEx expenses. But I think the data center expenses are going to start to dramatically level off as we ramp our next-generation offering that leverages AWS. And so, it just allows us to scale much more effectively, particularly to burst in a manner that we can’t today, because today we’ve got to build out for the highest capacity that our customers might require.

But one of the huge advantages about AWS is that that bursting is part of their model, and we can pay simply for what we use. But in general, the next-generation, multi-tenant offering, we believe will have a significantly lower cost basis that will allow us to operate it much more efficiently and much more profitably.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Okay thanks. Thanks guys.

Donald E. Brown

Thank you.

Stephen R. Head

Thank you.

Operator

Our next question comes from the line of Raghavan Sarathy with Dougherty&Co.mpany. Your line is now open. Please proceed with your question.

Raghavan Sarathy – Dougherty & Co. LLC

Hey good afternoon, thanks for taking my questions. Steve and Don, you both talked about the quarter being impacted by the mix shift to cloud. When I look at your second quarter guidance, you are guiding for a healthy 13% to 15% increase in revenue. I noticed you talked about flat subscription revenue. So, does your guidance contemplate the rebound in product revenue. Can you give us some sense for that? Then with the mix shift towards cloud, can you flesh out mainly on what we should expect for order growth for the year?

Donald E. Brown

Brian, the order growth for the year, for the full year, we continue to say 20%, and we had a very strong first quarter and we will just have to see where we are after the second quarter. Second quarter is going to be a very tough compare, because we had a great second quarter last year. We are expecting more product revenue in the second quarter. We’re expecting -- that’s just a normal part of our business and a normal sales cycle is the second quarter bookings are higher than first quarter bookings.

In addition, we’ve got a couple of items that we had deferred product revenue related items that we are expecting to be able to recognize. And so, that’s factored in there, so there is a number of pieces that get us to that range we were talking about.

Raghavan Sarathy–Dougherty & Company

Just to clarify, actually I wanted to know what sort of expectations we should have for the product order growth for the year? And then you sort of touched on the second quarter tough comparison, again I guess it will help to have some understanding on how should we think about the order growth for the second quarter?

Donald E. Brown

Well for – order growth for the second quarter could be down. We had such a strong quarter a year ago, but that was really a very large cloud deal in that quarter that makes the comparison the tough comparison, so we think we are going to have strong product orders in the quarter, and for the year, we’re expecting product orders to be comparable or maybe up slightly from a year ago.

Raghavan Sarathy–Dougherty & Company

Great. Thank you.

Operator

Our next question comes from the line of Mike Latimore with Northland Capital Markets. Your line is now open. Please proceed with your question.

Mike Latimore – Northland Securities, Inc.

Hey guys, thanks a lot. On the sales headcount, what kind of percent increase are you expecting at this point for the year?

Donald E. Brown

Well. We ended the quarter with, had it here Mike, and I am going to have to find it again. I think we ended the quarter with 131 worldwide and we’re expecting -- which is up from 118 at the end of the year. And we’re expecting continued growth throughout the year. Our budgets include hiring in the – towards the end of the fourth quarter in anticipation of 2015.

So that number is a bit overstated when we really look at comparisons, but right now we’re up by 13 people and continuing to hire from where we were at the end of the year. And so, we will see a continued growth through the year.

Mike Latimore – Northland Securities, Inc.

And then in terms of product orders, what percent came through the channel?

Donald E. Brown

Give me just a second. You may want to go on to your next question while I look that answer up.

Mike Latimore – Northland Securities, Inc.

I guess on the cloud business, what’s the latest thinking in terms of gross margin on the cloud business when it gets to, say more mature level?

Donald E. Brown

I’ll answer your last question now. So the partners were – I think your question is how much partners as part of the premises business, was that it?

Mike Latimore – Northland Securities, Inc.

Yes.

Donald E. Brown

It was 48% of the premises orders in the quarter. And margins on cloud, we are still targeting 70% longer-term. The new next-generation platform will be released, and we’re going to be seeing how that performs over the next year, continue to improve our margins on our CaaS operations as we’re getting more scale and volume there. We’re still targeting 70%, but it is still going to be a ways up before we get there.

Mike Latimore – Northland Securities, Inc.

Are you seeing any more opportunities to covert on-premise customers to cloud, [the change]?

Donald E. Brown

It is we’re seeing more and more interest from premises customers who are looking to move to cloud. I think a lot of our customers are looking forward to next month at INTERACTIONS to understand exactly what our – what we’re going to be unveiling, and what options they will have for continuing on prem or moving to our single-tenant CaaS offering or to this next-generation multi-tenant offering.

Mike Latimore – Northland Securities, Inc.

Fair enough. Thank you.

Donald E. Brown

And then, following up on that Mike, although we had a lot of good cloud business in the quarter, it continued to be mostly by new customers, but we did have a couple of current customers that were either expanding or adopting cloud. So we’re seeing a little bit of it, but most of our cloud business continues to be driven by new customers or already existing cloud customers.

Mike Latimore – Northland Securities, Inc.

Well. Thanks.

Operator

(Operator Instructions) Our next question comes from the line of Craig Nankervis with First Analysis. Your line is now open. Please proceed with your question.

Craig Nankervis – First Analysis Securities Corp.

Thank you. Good afternoon. Don, I’m just curious what is the prospect of introducing pure relatively soon is doing to discussions about your cloud -- your cloud offerings overall? Is that additive to cloud discussions and cloud pipeline at this point? Is it neutral to the pipeline? Is there is any color you can provide on this?

Donald E. Brown

Yes, well I think for the most part, we’ve done a good job of just keeping that off by something in the future. As you know, it is always tough for a technology company to introduce some new technology either as a replacement or as an addition without confusing customers, and worse yet,causing them to freeze their decisions. So we were trying to introduce pure cloud in a manner that ideally gets us into new opportunities, because it will allow us to address markets, certain customer configurations that we couldn’t do effectively before.

While making it clear to customers, our current customers that it will be a while before the next-generation offering really has all the functionality, the richness of functionality that we have in our current offering to serve as an effective replacement. So we are early only, but that’s the line we are trying to skirt and really trying to use it to get us into new opportunities.

Craig Nankervis – First Analysis Securities Corp.

Is there a potential for you to have pure cloud business in Q2?

Donald E. Brown

Not in Q2, I mean in Q2 we’ll at INTERACTIONS, we will be unveiling the new offering. We will be doing some initial customer trials, actually some customer implementations. Any revenue would be pretty minimal in Q2 and probably even in the orders. We are hopeful that if the initial deliveries go well that we can start to open this spigot more in Q3 and then really be cranking in Q4.

Craig Nankervis – First Analysis Securities Corp.

Okay. Thank you for that. Steve, just curious on gross margin. We know that it can move around just depending on mix pretty -- can move around pretty consistently. Do you think that where we ended up for Q1 is perhaps a low point? How do you – is there any commentary about gross margin for Q2 or just tough to say?

Stephen R. Head

It’s kind of tough to say, it’s going to be a mix issue. On how much professional services we are able to deliver is going to affect services margin product. It’s going to be the mix of orders we receive and how much hardware is associated with them. So – if I can’t predict exactly, we have our expectations, but it is based on a lot of assumptions, a number of them we’re going to be wrong on because of the nature of it.

Donald E. Brown

Right, right.

Craig Nankervis – First Analysis Securities Corp.

Okay, fair enough. That’s all I have. Thank you very much.

Operator

Thank you. Our next question comes from the line of Josh Goldberg with G2 Partners. Your line is now open. Please proceed with your question.

Josh M. Goldberg – G2 Investment Partners Management LLC

Hey guys, a couple of quick questions. I guess, first if the order pattern would have been 50-50 in terms of cloud verus product, do you have a rough sense on what you thought the revenues and the earnings would have been with those have been? Would those have been more in line with what you initially thought?

Donald E. Brown

Yes, Josh, I mentioned earlier that if it had been 55% rather than 59%, revenues would have been up 11%, we’d been well over $80 million. If it is 50%, it would take it up another step function, so if we were up 8% to 11%, it would have been up maybe about 14%, and we would have definitely been profitable, not excessively profitable, but we would have been profitable for the quarter.

Josh M. Goldberg – G2 Investment Partners Management LLC

Okay, and remind me -- that was your expectation going into the year was 50-50 split or was it --?

Donald E. Brown

We said 55% to 60% on the year.

Josh M. Goldberg – G2 Investment Partners Management LLC

Okay, got you. And then just someone else’s question just on the gross margin, the product gross margin number was a little low. Was that just a function of more hardware cost or some other functions on the product side being so low this quarter?

Stephen R. Head

It is just a mix in a quarter. It varies quarter-to-quarter, and we’ve had other quarters, it’s been in the 70s. So, it’s just going to be the mix in the quarter. there wasn’t anything specifically about the quarter that stands out.

Josh M. Goldberg – G2 Investment Partners Management LLC

Okay, thanks so much.

Operator

Thank you. Our next question comes from the line of George Prince with RBC. Your line is now open.

George Prince – RBC Global Asset Management Inc.

Hey, congratulations on a great quarter.

Donald E. Brown

Thank you.

George Prince – RBC Global Asset Management Inc.

You’ve had these announcements for the new offices and the new hires, I was wondering if you could talk about what gives you the confidence to expand like that, and how long do you think the step function expansion will cover you before you need to do it again? Thank you.

Stephen R. Head

Yes, I don’t think it is so much a step function, it’s a pretty much continuous expansion that we’ve been on, and what we try to do is have it aligned with the order growth, which we think is the best single metric for gauging the progress of the business, and it’s certainly the one that has the non-financial person in the room I’d pay the most attention to.

We just want to grow the underlying business and continue to book orders and do that at a fairly aggressive rate, which means that we are taking business from competitors, we’re growing faster than the intrinsic market is, we’re increasing market share, and we’ve made the decision that we’re going to offer our customers these three ways of consuming our software, three different ways of placing orders whether traditional premises-based software or single-tenant cloud or multi-tenant cloud.

So as long as that continues to grow at the sort of clip that it has been in excess of 20% year-over-year, then we’re going to continue to plow forward and while not getting ahead of that sort of order growth, we’ll try to march along with it so that we can fuel that fire, and then we’ll hope that we can articulate to analysts and the markets what we are doing, and explain the apparent masking effect that happens with the reported financials when the cloud portion of that business as it did this quarter lurches along even more quickly and hurts the apparent profitability.

We do think that over time, we will get more efficient. We are already seeing some of those efficiencies with our single-tenant cloud offering, but we’ve now been at this for about five years, we’ve learned a lot, and we’ve reflected that in this next generation offering, and we really think that we are going to be able to operate it in a much more highly efficient manner and one that is far more profitable for us.

George Prince – RBC Global Asset Management Inc.

Looks terrific and obvious to me, so thank you and good luck?

Stephen R. Head

Thank you.

Operator

Our next question is a follow-up from the line of Raghavan Sarathy. Your line is now open.

Raghavan Sarathy – Dougherty & Co. LLC

Thank you. Steve, you made some reference to there could be some impact on professional services. They are doing more cloud orders, I’d imagine the services revenue will continue to grow strong, so can you maybe clarify the comment what you mean by that? And then, I’m kind of struggling at how we can to the revenue guidance, so I’m thinking it maybe it kind of may be the professional services revenue would continue to grow at the same pace we saw in the first quarter.

Stephen R. Head

We are seeing some dramatic increases in professional services over the last few years, some of it was driven by both large premise engagements we’ve had and some of our private cloud engagements we’ve had. We’ve seen overall though, when we look at cloud engagements, the professional services are a smaller part of the transaction and they are per premises.

If we see continued shift to the cloud and that as we are seeing, we are not expecting to see the growth in professional services like we’ve had for the last couple of years. I think we are going to have to go another quarter and see what comes in. It is really -- there is some large engagements we are working on that could have significant professional services, and that’s going to change where we would be for the year. So, we are in a – we’re going to have to continue to monitor it from our standpoint to see what direction it is going to be going.

Raghavan Sarathy – Dougherty & Co. LLC

And then Don, you kind of touched on this. I think a couple of (inaudible), you talked about sort of improving the transaction volume by $250,000 to $1 million, also the new customer count is down year-on-year. What are some of the factors contributing to that amd how we are trying to fix that?

Donald E. Brown

Well, part of it is just the normal sort of volatility we see. The first quarter is always a tough one regardless, and we ended up focusing more about energies on some larger deals, and you saw that the average sales price went up, but the longer-term backdrop of that is focused on the midmarket developing a sales force that is capable of going after and winning more of those deals to provide us kind of a base layer of revenue and orders, and we really think that’s coming along well. The forecast that we see for Q2 and the rest of the year looks good, pipelines are building nicely.

So we don’t really worry too much about the exact numbers that happen to fall within one quarter, but it does remain important to us. I mean it’s wonderful that we’re getting pulled into bigger and bigger deals, but we just want to complement that part of our business with something that’s oriented toward a larger number of transactions.

As I mentioned, partly that just helped to build the brand and be involved in more deals, and we’ll be talking more next month but the whole next-generation effort isn’t just about creating a new version of what we have but offering a complete suite of additional applications that go beyond what we can functionally offer today, and so that will provide us an opportunity to go back to those customers and sell them additional services that we think will be important for building our pipeline for years to come.

Raghavan Sarathy – Dougherty & Co. LLC

Okay thank you.

Operator

Thank you. With that I’m not showing any further questions in the queue, I would like to turn the call back over to management for any closing remarks.

Donald E. Brown

Well thanks everybody. I know it’s tough looking at a company like us that’s making the transition from a fairly simple revenue model to a more nuanced one, but we’re pretty excited about the progress that we’re making, and as I said, we really stay focused on looking at the intrinsic growth of the business and we made tremendous progress there in Q1 and look forward to continuing that throughout the year.

Operator

Ladies and gentlemen thank you for participating in today’s conference. This does conclude the program. You may all disconnect.

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