Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Zix Corporation (NASDAQ:ZIXI)

Q3 2010 Earnings Call Transcript

October 25, 2010 5:00 pm ET

Executives

Geoff Bibby – VP, Corporate Marketing

Rick Spurr – Chairman, CEO and COO

Mike English – Chief Accounting Officer and Controller

Analysts

Mike Malouf – Craig-Hallum

Fred Ziegel – Blue Water Capital Markets

Jeb Terry – Aberdeen Investment

Jon Evans – Edmunds White Partners

Operator

Good day, ladies and gentlemen, and welcome to Q3 2010 Zix Corporation Earnings Conference Call. My name is Peggy, 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) As a reminder this conference is being recorded for replay purposes.

I would now like to turn the conference over to host for today, Mr. Geoff Bibby. Please proceed.

Geoff Bibby

Thank you, Peggy. Good afternoon. I am Vice President of Corporate Marketing for Zix Corporation. Thank you for joining our 2010 Q3 conference call. You can find our earnings press release on our investor website at investor.zixcorp.com. The earnings release contains instructions for accessing and recording of this call.

Our Chairman and Chief Executive Officer, Rick Spurr will provide an overview of the company's performance in the quarter, and then our Controller, Mike English, will give you details of our financial results. Later in the call they will answer questions from analyst and institutional investors. Listeners can also submit questions during the call to our investor relations' mail box at invest@zixcorp.com.

Rick and Mike will provide forward-looking statement on matters such as forecast of revenues, earnings, operating margins, and cash flow, projections of our 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 website 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'm very pleased to turn the call over to Rick Spurr. Rick.

Rick Spurr

Thank you, Geoff. Good afternoon and thank you for joining Zix Corporation's third quarter conference call. I am pleased to report that we continued to deliver strong results again in Q3, where we set several Zix Corp financial records. These records including all time highs in revenues, adjusted EBITDA, adjusted earnings per share and bookings backlog are the result of our successful subscription model.

There are two key elements to what I just said. First, our core Email Encryption business uses a subscription model. The key benefit of the subscription model is recurring revenue recognized ratably over the service period. Recurring revenue means that we have revenue coming in every quarter based on our past efforts, so we don’t have to struggle every quarter to achieve the targeted result.

In fact, at the beginning of each quarter we already have in hand in our backlog about 90% of our projected revenue for the quarter. The subscription model therefore means that Zix Corp has a very dependable revenue stream and a highly predictable business. Recognized ratably means we amortize our subscription revenue monthly over the life of our service contracts. That ratable amortization means that Zix Corp should not experience large swings in revenue, because the impact of new contract revenue in any quarter will be relatively small compared with subscription revenue from our existing contracts. So, Zix Corp’s subscription model allows us to deliver revenue results that are both predictable and stable.

I said our ability to deliver yet another quarter of record performance was the result of our successful subscription model. The second key element in that phrase successful speaks to our ability to add new sales, while maintaining high renewal rates on the existing base. Zix Corp has delivered strong sales growth over the past several quarters, despite a very slow economy. Our year-to-date orders for the nine months ending September 2010 are 59% ahead of the prior year period.

The $6.5 million of new first-year orders so far this year is more than our total new first-year orders for all of 2009, and as a reminder that 2009 total included our all-time record for new first-year orders in Q4. So we are seeing very solid sales performance thus far in 2010. We saw that very solid sales performance even in the third quarter this year. The third quarter has traditionally been our weakest quarter for Email Encryption sales, in large part due to the general slowdown of business during the summer.

We were therefore particularly pleased to report 2.2 million in new first year orders for Q3, which represents the strongest third quarter in the company’s history, and among the best sales performance we have seen in any quarter in our history. That success is driven by strong performance across our three core verticals, health care, finance and government. This broad-based demand results from general heightened awareness of the need for Email Encryption as part of an overall IT security strategy, plus the customers’ recognition of our differentiated, world-class service offering.

Potential purchasers of our services are increasingly aware of the security vulnerability of unprotected e- mail and of the business risks of exposing sensitive information in e-mail. Privacy and data breach legislation has put the focus on the potential downsides of sending sensitive information in unencrypted e-mail. Potential purchasers are concerned about penalties and customer notifications, but more importantly, about the reputational risk of disclosing customer data.

Regulations that mandate encryption of e-mail contain protected information, or they provide safe harbors from data breach rules if the e-mail was encrypted shine a bright light on the inherent insecurity of today’s most prevalent means of business communication. That increased awareness contributes to demand for our services. The risk of fines and a public embarrassment due to data breach notifications have prompted many companies to adopt e-mail encryption, because they are subject to Federal legislation such as HIPAA and HITECH, or State legislation such as in Massachusetts, Nevada and Washington. But we also are seeing a more pervasive appreciation of the need for e-mail encryption for data security across industries, including those that are not necessarily subject to privacy regulations.

We hear this from our distribution partners, who tell us that their customers from a variety of industries were asking for e-mail encryption. We have seen a shift in customer mix with an increased number of smaller deals. So we broadened our distribution, while maintaining a focus in our traditional core verticals. This is reflected in the continued growth in orders coming from some of our VAR and MSP partners, in addition to the more than 20% of our new first-year orders, which come from our OEM partners.

We believe this trend towards greater sales coming through third parties indicates a market for e-mail encryption that has gone mainstream. Whenever customers receive technology [ph] through trusted providers, who happen to be of distribution partners. When our partners own customers are asking for e-mail encryption, the partners begin to suggest our solution to their other customers, which feeds on itself and creates even more demand for our service. We are pleased of course with this virtuous cycle of demand we see in the market for our technology, and with the strong growth over last year’s sales.

Sales success in our core verticals is still the key driver of our results. We saw strong demand in healthcare during Q3. We signed one of our largest deals in years with a leading health system, which we hope to name publicly soon. We also announced the signing of a new Blue Cross Blue Shield customer, which was a competitive win back from another vendor. Due to amendments to the Federal HIPAA rules contained in the HITECH Act we see covered entities pressuring their business associates and contractors to adopt e-mail encryption.

We believe there are still a lot of companies out there who are covered by HITECH, and haven’t adopted a solution for e-mail encryption. So, we anticipate continued demand in the healthcare sector.

Financial services remains another strong vertical for us. During the third quarter, we surpassed the 1400 customer mark for banks, credit unions and other financial institutions. Our growth in this sector has been steady and impressive, including another competitive win back. We are continuing to add to our list of state banking regulators as customers, with Maryland and Arizona coming on board during the quarter. Our relationships and success with financial regulators continues to be a healthy source of demand for us. We have as customers all of the major Federal banking regulators, including one where we recently almost doubled the number of desktop licenses, and we now have 23 State banking regulators.

We have also had success elsewhere within the government sector. Earlier in the quarter, we announced our contract with The Alcohol and Tobacco Tax and Trade Bureau within the United States Treasury Department, bringing to five our total number of agencies within that department. We have active discussions under way with two other recognizable Federal agencies, one of which contacted us because of our relationship with the Securities and Exchange Commission. We also recently signed a deal to significantly expand our relationship with the state of Ohio to secure e-mail for that state government.

We are proud that we have earned the respect of the many influential Federal and State government agencies that trust Zix Corp to secure their earnings-mails containing sensitive information. We are quite pleased with the momentum we are seeing in this sector.

I talked a great deal about the overall demand for e-mail encryption remaining strong, but I haven’t said much about why Zix Corp specifically has been successful. Unlike most of our competitors, Zix Corp is focused on e-mail encryption as our primary business, and this focus has allowed us to build a best of breed solution. One can see the success through our consistently strong customer renewal rates, which were reflected in our record bookings backlog.

As we have stated on previous calls, we are the only email encryption services provider that offers a solution that is seamless and transparent to both senders and receivers who use our ZixGateway solution. We have developed strong content filters that enable our systems to automatically screen outbound e-mails and attachments to identify potential policy violations, and then automatically encrypt e-mails containing sensitive information.

What truly sets us apart is the ZixDirectory, our unique, shared Cloud-based network. ZixDirectory contains more than 23 million members, the largest such network in the industry, including some of the most respected institutions in the country, and this is growing at about 100,000 new addresses per week. So, new Zix Corp customers can immediately join a large community of users, with whom they can easily and securely communicate via our e-mail solutions.

Our distribution partners look to Zix Corp to provide them a competitive edge in their business offerings. These partners include leading companies such as Google, Symantec, Webroot, M86 and others including approximately 90 MSPs and VARs across the country. What these companies with reputations for leadership and excellence look to address in their businesses, they look for a best of breed solution and they found it at Zix Corporation. We just won a competitive opportunity against an extremely large global software company, where the customer chose our technology as a more robust solution that is more capable of addressing their needs. We won there just as we do in most competitive opportunities, because we understand our customers’ needs and are focused on delivering world-class e-mail encryption, so we offer the market a superior solution.

We are also testing new business models in an effort to diversify and increase our revenue. We recently added a new strategic reseller that is an electronic payment services provider. They will be using our technology to encrypt sensitive e-mails when providing back-office support to their customers. Typically our customers pay us a per employee charge to enable their employees to send and receive encrypted e-mails. In this case, our reseller pays us to enable its own customers to send and receive encrypted e-mail through branded portals. This reseller pays us by the message with an upfront payment to cover an initial quantity of messages.

We are optimistic that this new model can be a lucrative arrangement for us, but we have only recently launched this model with one of our reseller customers. So we haven’t yet seen a significant revenue impact. We continue to look for other novel approaches to expand our market reach.

In summary, Zix Corp is a leading provider of e-mail encryption services to influential companies in healthcare, finance and government with very credible distribution partners offering us solutions in a market that shows healthy demand under a subscription model that provides stable and predictable revenues. That is our formula for success and is driving our growth.

Just a brief word about e-Prescribing, we will complete our exit from the e-Prescribing business at the end of this year. The wind continues to meet or even exceed our expectations, and at the same time we have been able to maintain strong relationships with the physicians and health plans. I’m very pleased with the strong performance that Zix Corp has delivered so for this year, healthy demand, strong execution, best of breed technology and outstanding relationships with customers and partners have been the keys to our success, and we’re looking forward to continued strong performance as we close out the company’s first ever year of profitability.

Mike English, our controller, is here with me to fill you in on the financial details of the quarter, and to tell you that we are reiterating our revenue guidance for the year, and also raising our guidance for full year adjusted earnings per share. Mike.

Mike English

Thanks, Rick, and good afternoon to everyone. We are pleased to report strong results for the third quarter in our key financial metrics, revenue, GAAP and adjusted net income, EBITDA, and total bookings backlog. We have now achieved GAAP profitability in three quarters in a row, with GAAP net income of $1.8 million in the third quarter.

Our Email Encryption business achieved new first year orders during the third quarter of $2.2 million, a 67% increase over the third quarter of 2009.

I will now move to the details of our third quarter financial results, beginning with revenue. We've achieved companywide revenues of $9 million, which compares to $7.8 million for the third quarter of 2009. Email Encryption revenue was $8.5 million of this amount and e-Prescribing was approximately $500,000.

Email Encryption revenue for the third quarter grew $1.9 million, a 28% increase over the comparable 2009 figure. Our OEM partners drove approximately $440,000 of this revenue increase and the total OEM revenue contribution was a 119% improvement from the third quarter a year ago.

Our direct sales to enterprise and corporate customers, including to our resellers and MSPs drove the remaining growth. We continue to see cumulative growth in our subscription model with strong new orders combined with a high level of renewals.

E-Prescribing revenue for the third quarter was $500,000, which is down 57% from the third quarter of last year as expected, given our announced plan to exit this business at the end of 2010.

Looking at our Email Encryption bookings backlog, we ended the third quarter with $46.6 million, which is a 19% increase over the bookings backlog of $39 million at the end of the third quarter of 2009. As a reminder to everyone, our bookings backlog is comprised of contractual commitments that we expect to amortize into revenue in the future as the 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 approximately 57% of the Email Encryption backlog being recognized into revenue within the next 12 months.

Let's move on to look at our various margins, as well as the details on our expenses. We achieved a company-wide adjusted gross profit for the third quarter of $7.2 million, 80% of revenues. This compares to $5.8 million, 74% of revenues for the same quarter last year and on a sequential basis, it compares to $7.1 million or 79% revenues for the second quarter of 2010.

The Email Encryption adjusted gross profit for the third quarter was $6.9 million, 81% of revenues, compared to $5.5 million for the same period last year, 83% of revenue, the Email Encryption gross profit amount was a result of an increase of $1.9 million in revenue and an offsetting $500,000 in increased expenses.

While the Email Encryption gross margin percent appears to now be stabilizing as many of the shared fixed costs, previously allocated to e-Prescribing, have been shifted to Email Encryption. There will be a final shifting of approximately $700,000 in 2011, or $175,000 per quarter when the wind down is complete. This should have a minor impact on the gross margin percent for the Email Encryption business, and we expect the gross margin to improve as we grow revenue.

Our e-Prescribing adjusted gross profit was $272,000, 55% of revenue compared to $210,000 or 18% of revenues for the same quarter last year. This improvement is due to a $660,000 in lower revenues, being slightly more than offset by year $720,000 reduction in our cost of revenues driven by the wind down of the business.

We have lower headcount between periods, we are not incurring costs to deploy new doctors, and the business is being burdened with lower allocated cost, based on lower headcount and decreased time spent on that business segment.

With regards to company-wide operating expenses, adjusted R&D and SG&A expenses totaled $4.7 million in the third quarter of 2010, compared to $5 million for the same period last year. Adjusted R&D expenses were $1.3 million in the third quarter, a decrease of $400,000 while SG&A expenses were $3.4 million, an increase of $100,000. The R&D expense decrease from 2009 is primarily driven by lower headcount, resulting mainly from actions taken in our e-Prescribing segment to align expenses with the needs of our business.

Our company-wide adjusted operating margin for the third quarter was $2.5 million, 27% of revenues. This compares to a profit of $723,000 or 9% of revenues for the same quarter of last year. Our adjusted EBITDA for the third quarter was $2.9 million with an adjusted EBITDA margin of 32%, compared with an adjusted EBITDA of $1.1 million and adjusted EBITDA margin of 14% in the third quarter of 2009.

Our capital expenditures for the third quarter were $585,000. Depreciation expense for the quarter was approximately $362,000 and it's recorded in various P&L lines with approximately 76% been recorded in cost of revenues.

Cash and cash equivalents increased $2.1 million from the prior quarter. Compared to this time last year, cash and cash equivalents increased $7.2 million. We again delivered good results in cash flow from operations this quarter. This cash increase in the third quarter was driven by cash flow from operating activities of $2.1 million, which included three primary drivers. First, collections of our new first-year orders; second, payments from a larger base of our existing contracts; and lastly, the continued cost savings generated by the wind down of the e-Prescribing business. We achieved this growth in cash in the third quarter, while at the same time slightly lowering accounts payable and accrued expenses from the second quarter.

Our companywide adjusted net income for the third quarter was $2.5 million, which compares to $797,000 for the same period in 2009. Our adjusted net income for fully diluted share of common stock for the quarter was $0.04 versus $0.01 for the same period in 2009. This amount is also up sequentially from the second quarter, when we reported adjusted net income of $2.2 million and $0.03 per fully diluted share. Additionally in the third quarter, approximately 3.5 million outstanding warrants expired.

As we look to the fourth quarter, we are assessing our deferred tax valuation allowance. Zix has historically generated net operating losses; however, 2010 will be the first year in the company’s history for us to generate taxable income. As a result of historical net operating losses and the previous uncertainty, whether and when the company would attain profitability, we have historically recorded a full valuation allowance against the deferred tax assets generated by the losses, which was considered appropriate under Generally Accepted Accounting Principles.

Now due to our expected positive earnings for the year ended December 31, 2010, and our expectation of future positive earnings, we are currently reassessing this approach based on the guidance under Generally Accepted Accounting Principles and applicable tax law. We anticipate the completion of this analysis during the fourth quarter of 2010, and any adjustments will be reflected in our fourth quarter tax provision as a tax benefit. As of September 30, 2010, the deferred tax asset was at $111.5 million and the valuation allowance at $111.45 million or a net deferred tax asset of $48,000.

Moving on to the full year, we’re reaffirming our previously issued revenue guidance, and project companywide 2010 revenues to be between $35.2 million and $36 million, of which e-Prescribing revenues would comprise $2.5 million to $2.6 million.

For full year 2010, adjusted earnings per fully diluted share are now projected to be between $0.11 and $0.12 with approximately 67 million fully diluted shares outstanding. This guidance will yield a full year adjusted EBITDA margin in the 26% to 27% range, and an adjusted operating margin in the 22% to 23% range.

So in closing, I would just like to say again that we are very pleased with the results of our third quarter, and look forward to a strong finish for the year.

With that I will turn it back to Rick. Rick?

Rick Spurr

Thanks, Mike. We are obviously pleased with our results and anticipate finishing the year on a strong note. We have seen continued strong demand in our Email Encryption business across all of our core verticals, driven by an increased general awareness of the vulnerabilities of e-mail.

We have best of breed technology, supported by a superior and unique architecture, outstanding customer service and strong partner and customer relationships. I like to thank our shareholders for their continued support, our customers and partners for their business, and of course our employees for their dedication and hard work.

I’m looking forward to reporting on the end of the year results, and with that let me turn the call over to the operator for any questions.

Question-and-Answer Session

Operator

(Operator instructions) And it appears that our first question comes from the line of Mike Malouf with Craig-Hallum.

Mike Malouf – Craig-Hallum

Great. Thanks. Thanks, Rick, and welcome to the call, Mike.

Rick Spurr

Thank you.

Mike Malouf – Craig-Hallum

I have a question of little bit about on the new wins or the new first year orders, can you talk a little bit about how that breaks down by vertical, and I have seen some – obviously some recent success that Google has had with even some of the states, the article recently about the state of Wyoming, maybe you could tell a little bit about how they are doing in government and how that is helping you out?

Rick Spurr

Sure. Well, first of all, I will answer your questions in reverse Mike, as it relates to that state of Wyoming win, I don’t know if I’m happy or embarrassed, but we saw that when you did. Our arrangement with Google allows them to sell our services and report after the fact to us. So we actually hadn’t gotten a report on that win, and so it is not in our current numbers. So I guess all in all that is good news.

But the channels are doing exactly what we designed them to do. They get us reach, and allow us to satisfy demand not only in our core verticals, but really across all industries, and in corners of the world and certainly in the United States, where we might not have sufficient penetration or coverage. We can’t be everywhere. So, they have been great for us, and not only Google, but the 90 smaller ones I mentioned, and Symantec and Webroot.

With regard to where is the business coming from the distribution or new first-year orders, this quarter was not particularly different or unique as compared with prior quarters. For the full year thus far, for the first nine months, we have got 48% of our business out of healthcare, 28% from finance, and what is a somewhat surprising number in 2010 is the amount of new sales we’re getting from non-core verticals, so other, which is other than healthcare, finance, and government actually represents 14% of our sales thus far this year, and government is around 7%.

So good distribution and increasing use and demand for our technology beyond just our three core verticals, but the three core verticals are still the vast majority of what we do as you can see.

Mike Malouf – Craig-Hallum

Great, thanks. And if I could just have one follow-up question with regards to competition, I noticed in your prepared remarks you talked about the competitive win back that you had on the healthcare side, which is obviously encouraging. Can you talk a little bit about how competition is shaping up now, is Ironport/Cisco still the main competitor, and have win rates changed at all material? Thanks.

Rick Spurr

Thank you, Mike. Cisco continues to be our largest competitor. There is really not even a close second. There are others who have older technology, and Proofpoint’s technology is relatively new I guess, but we are not seeing a lot of them show up. The whole market is up, so we are engaging Cisco and these other guys as much and in some cases more than ever, but Cisco continues to be our biggest competitor. I wouldn’t say our biggest challenge.

We are very proud, again, of our architecture, and feel like we’re highly differentiated in reseller value and as you know, win most of the time. So, competition sometimes is expected certainly in a market that is heating up like this. So that is good.

Mike Malouf – Craig-Hallum

Thank you.

Rick Spurr

Thank you.

Operator

(Operator instructions) And our next question comes from the line of Fred Ziegel with Blue Water Capital Markets. Please proceed.

Fred Ziegel – Blue Water Capital Markets

Hi, Rick.

Rick Spurr

Hi, Fred.

Fred Ziegel – Blue Water Capital Markets

I don’t know how much visibility you have into the channels from the standpoint of where the sale ultimately ends up, but can you talk a bit about international and how you think about that market, and the drivers I assume are probably slightly different there than here?

Rick Spurr

Yes. So, we are excited in that we have got the product fundamentals in place. I think I mentioned on several other earnings calls, we have invested quite a bit in adding 12 languages to the product, including double-byte character languages like Japanese and Chinese, Korean and other Asian languages. And the next thing is for us to focus/consider investment in ramping distribution. So today we have distribution in the international markets from Symantec primarily, and Google has the right to sell, although we haven’t seen a lot of volume.

We have accommodated the sales in the UK, you know, with a small datacenter investment there, so they can keep their content on European soil to adhere to the European privacy rules that exist. But the volume has not yet shown up, and I believe it will show up when and if we decide to invest in more in country distribution, and work more closely with them to get that penetration. So it is an area of growth for us. The major investments in technology had been made, but the story is yet to unfold.

Fred Ziegel – Blue Water Capital Markets

When we shift gears back to the US, in the three states that have legislated Email Encryption, what has been the traction so far?

Rick Spurr

Well, the one where we are seeing the most impact, the most visible is without question is Massachusetts. And you know, a lot of these non-core vertical sales that I mentioned, certainly not all of them, but many of them show up as being in response to the Massachusetts law. So I had mentioned before Candle Company, Bed Bath & Beyond, and people that we didn’t even now cared, but now they have to care because of the law.

So, not cataclysmic, but contribution to overall increasing demand.

Fred Ziegel – Blue Water Capital Markets

How fast do you sense it's spreading beyond the first three states? Any lead on that?

Rick Spurr

We know there is active legislation in a lot of states, but I don’t care to guess or speculate on the speed of the political mechanism.

Fred Ziegel – Blue Water Capital Markets

Okay. And last question I guess for Mike, on the gross margin in the shared expenses you said running $175 million per quarter in 2011, what are they running at the moment?

Mike English

They are – as you might guess, they are running down to that number. They are probably just slightly north of it right now. We will certainly be very close to it as we speak around the 700,000 level.

Fred Ziegel – Blue Water Capital Markets

Okay. So the gross margin improvement in 2011 will be top line-driven, not coming from much in terms of reduced expenses?

Mike English

That is right.

Fred Ziegel – Blue Water Capital Markets

All right, thanks.

Rick Spurr

Thank you, Fred.

Operator

Our next question comes from the line of Jeb Terry with Aberdeen Investment. Please proceed.

Jeb Terry – Aberdeen Investment

Hi Rick.

Rick Spurr

Hi, Jeb.

Jeb Terry – Aberdeen Investment

I was intrigued by your comment about your signing another reseller in the electronic payment service provider space.

Rick Spurr

Yes.

Jeb Terry – Aberdeen Investment

Related to that, I'm wondering if there is a – if there's some shift in your R&D focus or concentration. It's, clearly, your R&D spend has come down because you're not in e-Prescription, but is there any redirection or any kind of increase in R&D that might have to happen in anticipation of this kind of business? If you could help us understand a little bit more of what that…

Rick Spurr

Yes, that is a good question, Jeb. They really are unrelated, but I will address both of them separately, because they both deserve some color. First of all, R&D, we have spent year-to-date around 4 million on R&D, and anticipate the run rate ticks to around 5. And that is robust, but not unreasonable for a company in an industry like this in its current state of maturation. Our technology touches a lot of different third party tools. So we’re constantly – in addition to upgrading our product suite all the time with just new feature function, and our product suite to remind you is ZixMail, ZixGateway, the ZixPortal and ZixDirect are the primary ones.

So we enhance all the products, add feature function, maintain our competitive advantage in many cases, and we then also have to make sure that we are keeping current with new releases of all sorts of infrastructure third-party products like Microsoft Outlook, Linux, DB2 and the various browsers, Firefox, Safari and internet browser.

So that is where a sort of a baseline of R&D investment goes, and then you know we added the 12 languages, and we also are investing to interface with our partner ordering systems, so that when these partners are attempting to process volume, we can make that as streamlined as possible, and hopefully bring them closer to the Zix family and model and retain them, and also automating a lot of our provisioning to just achieve faster implementation for our partners’ customers and scale.

In this area, we actually just filed a patent that is interesting. It is obviously available to the public. To your second point, the new strategic reseller we mentioned, the beauty of it is our technology can be applied in a whole variety of different ways, allowing us to attack the market in different ways without making a lot of changes to the fundamental technology. So in this particular case, think of this as a very large call center company. It is really more than that, but for purposes of this explanation think of it that way.

And they want to allow their inbound callers to communicate with them using e-mail, and some of the traffic is sensitive. And so to enable that appropriately they need encrypted e-mail. Well, it wouldn’t make sense for us to charge the call center operator for the number of people taking calls, and they didn’t want us to do that either. So we are flipping it around. We are really charging by the message that their customers – customer actually, the amount of traffic that they are going to generate. As we said, they will pay us upfront, but they are using the tools we have today. They use the portal and they compose encrypted messages sent into this customer of ours – who are a partner I am sorry, and they read and process and reply to those again using our normal portal technology. Did that answer your question?

Jeb Terry – Aberdeen Investment

So you can, in effect, charge by the drink instead of by the seats and –

Rick Spurr

And in this case, Jeb, that is right. The charge by the drink is the right way because it is so variable. It is not tied to a fixed number of employees, for instance, which is our normal model, but it is a function of how much volume their customers, who are consumers and people all over the world, how much they happen to generate. So we have to charge by the message in that model.

Jeb Terry – Aberdeen Investment

And is that going to impact – I'm trying to figure out what kind of scale that could represent. Does this address only a small part of their volumes? Or should it address a large part of their volumes or –?

Rick Spurr

It is going to be evolutionary, Jeb. They bought some message volume. It is the portals from us to accommodate up to 5 customers. Now even if they address one of those customers they could exceed the message volume bucket, but that is where they started, and they are going to work with this to get the first one or two off the ground and see where that goes.

Jeb Terry – Aberdeen Investment

Well, that sounds very exciting. I look forward to seeing it developed. And I presume there you could revenue in Q4 from this source?

Rick Spurr

Well, we will have revenue in Q4, because we did a deal already in Q3, and now it will start to amortize the revenue. So they made a commitment. They have paid us the money, so we can start to take revenue on that.

Jeb Terry – Aberdeen Investment

Great. Thanks very much. Good quarter.

Rick Spurr

Thank you.

Operator

Our next question comes from the line of Alan Evans with Edmunds White Partners. Please proceed.

Jon Evans – Edmunds White Partners

It is Jon Evans. Can you help me just understand a little bit – you did a great job sequentially increasing your EBITDA margins. And if you look at your bookings, your bookings have accelerated. You would think that your revenues would start to accelerate. Can you help us understand kind of with your model where you think you guys potentially could drive EBITDA margins over time? And kind of what the incremental margins are from here?

Mike English

Sure. Well, first of all, mathematically revenue will go up when orders go up, as long as we maintain good retention rates with our current base. And we indicated in this call that we are having good retention rates, and you will see the effect of those two elements, good retention rates and new sales, increased new sales, show up in the backlog. And the backlog is a window to revenue. So as the backlog grows and the portion of the backlog that represents 12 months out, as that number grows, that can highly correlate, or does highly correlate to revenue.

Jon Evans – Edmunds White Partners

Right. And so your backlog bookings, I think in Q2 was up 16.4% year-over-year and in this quarter it was up 19.5%. So we should see revenues probably start to accelerate. So can you just help us understand – do you have to invest a lot or kind of what the incremental margin is? Because you did a great job on EBITDA margins sequentially.

Rick Spurr

Yes. So let me address that to the extent I can. I’m going to give you a vague answer, because we hadn’t done guidance for 2011 and beyond yet, until we do that, we are not going to project any real numbers. But our gross margins are good now and with the exception of the small hit that we might see from the 700 k that Mike mentioned that is going to move, which is relatively small. As the revenue goes up, we’re even hoping and expecting that you will see a little bit of improvement in gross margin, but even at 80%, it is a good number.

Below the line then, as you know, you have got sales and marketing, R&D, and G&A. And I will take that in that sequence. Sales is highly, the channel content and the channels we have built over the years is what gives us leverage there. So unquestionably we can grow top line revenue merely by the channels volume increasing. So, we have now, as I mentioned, 90 MSPs and value-added resellers in addition to the large OEM guys, and they drive a lot of volume for us, and our costs had to do with recruiting new ones, and supporting the ones we have.

So relative to direct sales, you get a lot of top line growth with a lot less investment. To put that in context, in ’09, for all of ’09, those third-party channels contributed 33% of our volume. Through the first three quarters of this year they have contributed 54% of our volume. If you break that down on a quarterly basis, and 2009 they were generating on an absolute basis about 0.5 million a quarter for us, and so far through 2010 generating over $1 million a quarter, about 1.1.

So, good leverage and good scalability, given the investments we have made in that third party distribution. Now that is not to say we wouldn’t invest in sales and marketing. But I think you will continue to see our investments there being reasonable and modest, as opposed to radical.

On the R&D side, we came in to the year with a plan to run R&D at about at 16% revenue. I think we are actually running at 15% of revenue, and I guess philosophically I would say I think R&D needs to run between 12% and 18%, depending upon where you are in the industry’s evolution. So we’re kind of right in the sweet spot there at 15%. We are going to look at new things we could do and it is possible they could drive more investment there, but absence of sort of new groundbreaking thing, you got a pretty healthy robust investment R&D.

G&A, we are a small public company, and so we invest a fair amount of money already in G&A, and our goal is – I’m not saying we won’t invest anything, because I don’t want to tie my hands, but our objective as a management team is to keep that number tight, and try to get all the leverage in the top line we can. So that is about all I can say right now.

Jon Evans – Edmunds White Partners

So, I mean, is it – I mean, if you just do that quick math with the gross margins you have, I mean, it seems like your incrementals are much higher than your existing EBITDA margin. In other words, if you add another $1.00, you should have EBITDA leverage. Is that a fair assessment?

Rick Spurr

Yes.

Jon Evans – Edmunds White Partners

Okay. Thank you so much.

Rick Spurr

All right. Thank you.

Operator

We have no further questions at this time. I would like to turn the presentation back to Mr. Rick Spurr for closing remarks.

Rick Spurr

All right. Thank you. Well, as we announced last week I will be heading down to the SRA investor conference in San Francisco tomorrow. So if anyone is interested in arranging a meeting while I am out there, please contact our new IR advisor, the MKR Group to coordinate the details. Their contact information can be found on the investor portion of our website. Otherwise, I look forward to speaking with you during the quarter, or at least when we report year-end results at the beginning of next year. Thank you again for your interest and attention.

Operator

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

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Zix CEO Discusses Q3 2010 Results - Earnings Call Transcript
This Transcript
All Transcripts