ServiceSource International's (SREV) CEO Michael Smerklo on Q2 2014 Results - Earnings Call Transcript

ServiceSource International (NASDAQ:SREV)

Q2 2014 Earnings Call

July 31, 2014 4:30 pm ET


Eric Bylin -

Michael A. Smerklo - Chairman of the Board, Chief Executive Officer and Member of the Service Executive Industry Board

Ashley Fieglein Johnson - Chief Financial Officer and Principal Accounting Officer


Jennifer Swanson Lowe - Morgan Stanley, Research Division

Scott R. Berg - Northland Capital Markets, Research Division

Edward Maguire - CLSA Limited, Research Division

Bhavan Suri - William Blair & Company L.L.C., Research Division


Good day, everyone, and welcome to the ServiceSource Second Quarter 2014 Earnings Results Conference Call. This call is being recorded. With us today from the company is Mike Smerklo, the Chairman and Chief Executive Officer; Ashley Johnson, the Chief Financial Officer; Eric Bylin from Investor Relations. At this time, I would like to turn the call over to Eric. Please go ahead.

Eric Bylin

Thank you for joining us. Before we begin, I'd like to remind you that during the course of this webcast and call, we may make projections or forward-looking statements that reflect our views as of today and are based upon the information currently available to us. This information will likely change over time.

By discussing our current perception of our market and the future performance of our company and our solutions today with you, we are not undertaking an obligation to provide future updates. We caution you that such statements are just projections, and actual events and results may materially differ from what we discuss. Please refer to the documents we have filed with the SEC. These documents contain and identify important factors that could cause the actual results to materially differ from those contained in our projections and forward-looking statements.

During the course of this call, we will also be discussing certain non-GAAP financial results. We direct your attention to a reconciliation between GAAP and non-GAAP measures, which can be found in today's earnings release posted on the Investor Relations portion of the ServiceSource website.

And with that, I'll turn it over to Mike.

Michael A. Smerklo

Thanks, Eric, and welcome to the call. As you've seen in today's press release, this was a challenging quarter. Ashley will share more of the financial details, but I want to start by providing some perspective on what we've uncovered in the last 90 days and then move quickly to our plan for ensuring growth and profitability in our business.

On almost all counts, this was one of the toughest quarters in my 12-year history running ServiceSource, particularly when I consider our outlook just 180 days ago. That said, we did have some positive highlights in the quarter. We added more than $3 million in new subscription revenue, including some great competitive wins from our Scout product line. We also signed a number of expansions with our existing managed services customers. The trend of customer expansion has been consistent and in the past 5 years, our average contract size per customer logo has increased by approximately 60%. We also signed a large new deal with a Fortune 100 company, our largest new contract in the last year. I applaud our sales team on their execution this quarter. But as the results show, both our top line and our margins were challenged this quarter, and we recognize the need to take immediate action. However, I want to emphasize that ours is a complex, global business and restructuring it will take time. 90 days ago we acknowledged a slowing ACV trend, and we attributed this trend to our unbundling strategy and hybrid go-to market approach. We also discussed the fundamental differences between our managed service pay-for-performance business and our SaaS product business, and the difference of go-to-market motions required for each. We also acknowledge our underinvestment over the last 3 years in our Managed Services business.

Before I share our plan, I want to provide some context on how we got to where we are today. About 2 years ago, we unbundled our offering to give customers a choice and successfully launched Renew OnDemand with some phenomenal initial customers. In doing so, we transitioned ServiceSource from a BPO services company to a software and services company. The change was necessary to expand our market opportunity and to meet customer demands. But with this change came difficult and unique challenges with consequences we are working through today. And while we unbundled our go-to-market strategy, we kept the 2 businesses fundamentally intertwined. As a result, they both became suboptimized, leading to a slowing revenue growth and higher cost to deliver. With the help of an outside consulting firm, our Board of Directors, and my entire leadership team, we undertook a 90-day strategic review to determine the root cause of the underperformance in our 2 businesses and create a roadmap to move them from intertwined to independent.

In summary, the strategic review put a spotlight on our current operating strategy, including, but not limited to, our unbundling efforts. With unbundling came the intense focus required to launch a SaaS business at the expense of innovation in our core BPO business. We estimate that 90% of our discretionary spending and all of our marketing messaging over the last 3 years supported our SaaS business. This resulted in an inability to decrease our cost to serve through process automation and labor relocation, as well as a commoditization of our BPO services. And because we maintained a relentless focus on meeting or exceeding customer expectations, we saw labor costs rise and headcount grow.

Our operating model had another consequence and that it tied our product strategy too closely to our services strategy. In doing so, in our early stages of the product, the scope of the technology portion of the solution was not well defined as the focus and the sales process was on the business outcome, not the technology features and functionality. This is a very typical BPO sales process but a dangerous technology sales process.

We have uncovered that many of our early statement of work had unbundled scope, which has resulted in very high professional services cost and also high managed services cost as the team worked hard to bridge any gaps between customer expectations and the capabilities of the technology.

In short, our intertwined operating model led to ambiguous statements of work, unclear selling motions, elongated selling cycles and unprofitable engagements.

On a more positive note, as part of the review, we reviewed customers, prospects and the market in general. And it remains clear that the market for recurring revenue management solutions is robust and under-penetrated and that we continue to enjoy no major direct competition. As such, we continue to view these challenges as an execution, not a market problem.

To net it out, our hybrid operating model is the root cause for our challenges today. The best way for us to restructure this business is to decouple the BPO business from the startup SaaS business and manage them separately. To do so, we developed the following 5-point restructuring plan, an overview which is provided on our Investor Relations website.

The first and most of important step of this process is organizational design. Effective immediately, we're establishing separate business units with separate leadership for our SaaS and Managed Services. Our SaaS business, recently renamed Cloud & Business Intelligence, will continue to be led by Richard Campione as President. This is a role he has held since early 2013, and he will continue to focus our efforts on innovation and product differentiation across our software assets in the recurring revenue management marketplace. In addition, he will now own customer-facing activities and go-to market resources for the Cloud & Business Intelligence division.

In our Managed Services business, we've launched a search for a new president who will own the P&L for this division. The president of this BPO business will own customer-facing activities, go-to market resources, and delivery assets for the division. This new executive will focus on process automation, quality of delivery and lowering cost-to-serve. While we are recruiting this new executive, I will be acting in this role. At the corporate level, we will maintain centralized functions for finance, IT and legal, Human Resources, corporate marketing and strategy. I have streamlined my leadership team to better reflect this new organization. The smaller leadership team will lead to faster and more coordinated decision-making across the entire company.

To summarize, our BPO and SaaS business units will run independently but share corporate -- core corporate functions to allow each business the maximum flexibility to achieve their goals.

The second of our plan is to align our customer-facing activities and go-to market motions to each business unit, including sales, marketing, pricing, contracting, customer success and professional services. This will allow us to articulate a crisp and distinct value proposition to the distinct buyers reach offering, the CEO and CFO for our BPO services and the CIO in sales ops team for our SaaS offerings. Because these changes are customer facing, we expect to take the remainder of the year to complete this realignment and avoid any disruption to our current pipeline and customer deployment.

The third element of the plan focuses on driving outstanding execution and reducing inefficiencies and cost to serve in our core BPO business. With our long-standing experience and success in this business, we know that there are 5 key pillars that we must refocus on. First, our value proposition, which is our ability to drive real results for our customers based on our unique combination of industry experience, technology, data and analytics. Second, workforce management. Our ability to drive efficiencies and lower cost to serve through investments in training and in cost-optimized locations. Third, process excellence. Our ability to define key processes and workflows and automate as much as possible via technology. Fourth, our aligned customer engagement model. Having a tight coordination between customer touch points and service delivery. And finally number five, our economic model. Our ability to contract with customers with statement of work that align with our target gross margins and cost to serve.

What I can say with great confidence today is that the first of these pillars, our value proposition, remains strong in the marketplace. However, it is very clear that the other 4 pillars have suffered from underinvestment and explain the financial performance Ashley will outline further today. As such, changes will not be easy or fast and will take several quarters to implement.

The fourth element of the plan focuses on scaling our Cloud & Business Intelligence division. We are currently finalizing integration of Scout; and through that integration, establishing a stand-alone SaaS go-to market organization that supports its technology-driven sales process. We will also improve our engagement model with customers through more clearly defined statement of work, allow for a more cost-effective delivery model, and higher customer satisfaction.

Finally, the fifth element of the plan is aimed at rationalizing our overall P&L, beginning with a close look at our global expense infrastructure. As Ashley will outline shortly, we've identified 3 target areas for financial improvement in the second half of this year. However, we expect these improvements to have little impact on the outcome for 2014, but should enable us to run our business more efficiently and with more scale across the 2 business units in 2015 and beyond.

Before I turn the call over to Ashley, I want to close by reviewing some of the highlights from the quarter. In our Managed Services division, we signed several new logos, including one for a major deployment with a Fortune 100 technology company. This is our largest new customer addition in the last year. In our Cloud & Business Intelligence division, we closed a number of new logos including Marketo, IntraLinks and Rackspace. And we added a total of more than $3 million of subscription ARR in the quarter between our 2 SaaS products.

Over the last 6 weeks, we've successfully migrated our largest Renew OnDemand engagements to our new V2 platform with improved stability and dramatically increased performance based on our new Big Data in-memory architecture. The customer response has been very positive, and we look to migrate the rest of our customers to the new platform. On the Scout side, we expanded our partnership with Zuora by launching Scout Link for Zuora, allowing customers’ success teams to leverage usage and subscription data for deeper customer engagement.

As I said at the beginning of the call, restructuring our business will take time and effort. I plan to report quarterly on our progress. For today, I want to net out what this means for investors. We are acknowledging the challenges to our business and tackling them directly. We have begun a 5-part restructuring plan that will take significant time, effort and patience to execute successfully. The result of this effort will not be immediate. We are positioning the business for renewed growth and profitability beyond 2013. And my leadership team and I believe in the market opportunity in front of us. We are clear on the plan that I shared today and we are fully committed to restoring ServiceSource to the growth and profitability we know this business can generate.

And with that, I'll turn the call over to Ashley.

Ashley Fieglein Johnson

Thanks, Mike. I'd like to take a moment to give some commentary on our Q2 results, as well as provide an update to our guidance.

As we provided previously, there are slides posted to our website with the details for our guidance as well as GAAP to non-GAAP reconciliations.

Please note that we reference non-GAAP revenue, which excludes the impact of the haircut to deferred revenue from our acquisition of Scout, as required by purchase accounting. The remainder of our non-GAAP metrics do not include noncash expenses related to stock-based compensations, the amortization of internally developed software, the amortization of intangibles acquired from Scout, acquisition-related costs and noncash interest expense related to the issuance of convertible notes. As always, you can find a reconciliation of GAAP to non-GAAP metrics in today's press release and on the Investor Relations section of our website.

Now let me turn to our Q2 financials. As you have seen, Q2 results were below our expectations across most key metrics. And as Mike noted, we attribute the further deterioration of our financials to the challenges of our hybrid operating model and unbundling strategy.

Starting with bookings, while we don't provide a numerical update for Managed Services ACV on a quarterly basis, we did add several new accounts to our portfolio this quarter, including the largest new customer additions in over a year. Of the new business we added, approximately 50% came from our existing customers through expansions and approximately 50% was from new logos. We also added more than $3 million of new SaaS subscription ARR in the quarter. Our ACV churn rate in Q2 remained in line with our historical target of an annualized 90% ACV dollars retention.

Turning to revenue. Non-GAAP revenue was $66.3 million, reflecting a decrease of 2% over prior year. This came in slightly below our guidance primarily due to a significant miss in our Managed Services business.

In North America, revenue grew 2% year-over-year as the new business signed in 2013 began to ramp, offset by underperformance in the installed base and the restructuring of some of the contracts in the latter half of 2013. International regions showed a decline with revenues decreasing 10% year-over-year in the EMEA region and 7% year-over-year in Asia Pacific, due primarily to the slow acquisition of new business, compounded by some regional customers taking business back in house. Due to the launch of our Tokyo operations last year, we saw an uptake in new business acquisition in Asia Pacific this quarter, and we remain confident that our global operations represent a significant competitive advantage and optimistic that this negative trend will reverse as we increase focus on our Managed Services operations around the globe.

Non-GAAP gross margin for our consolidated business was approximately 30%, which is at the low end of our guidance and down 15 points year-over-year. The compression in margin was driven by the lower revenue and operational challenges faced by Managed Services, compounded by salary increases for our North American inside sales organization.

In addition, to better support our customers, we increased investment across several key accounts, both in terms of Managed Services and professional services personnel. This increased allocation of resources has continued to compress our gross margins across both of our business units. These pressures on gross margins have been offset modestly by the improved operational scale we've achieved in our subscription business.

As Mike shared, our gross margin challenge was a key area of focus for us during our 90-day strategic review, and one of the areas that will take time to correct. Our hybrid operating model and unbundling strategy of the prior 2 years created complexity and confusion in the scoping of our early Renew OnDemand engagement, resulting in customer satisfaction challenges and escalating personnel and therefore, cost commitments. We are currently working with both existing and new customers to establish well-defined statements of work and to ensure successful and profitable deployment. In addition, we're in the process of reviewing all customer engagements to optimize our performance, reduce our cost to serve and ensure that our contracts can be executed in a manner consistent with our target gross margins over the long term.

This process will take time, but it's critical to reversing the downward trend we have experienced in recent quarters on our gross margin profile.

I'll turn now to the segment view, starting first with Managed Services. Q2 revenue for Managed Services was $58.6 million, a 7% decrease year-over-year. As a result of the shortfall on revenue and the increase in our cost to serve as a result of the past several years' underinvestment in our Managed Services, non-GAAP gross margin for the business unit came in below our guidance at 29%.

Turning now to Cloud & Business Intelligence. Our non-GAAP subscription revenue in Q2 was $7.5 million, an increase of 173% year-over-year and within our guidance range. The sequential decrease in the quarter from Q1 is attributable to a onetime catch-up of deferred revenue in Q1 compounded by a contraction in our subscription revenue from a couple of our early customers. Non-GAAP gross margin for our SaaS business was 77%, as improvements in our architecture have enabled some economies of scale. Q2 professional services revenue was approximately $200,000, within our guidance, while our professional services and support costs totaled $3.3 million.

Moving on to profitability. Our non-GAAP operating costs were above our expectations for the quarter due primarily to the third-party consultants and other work related to the 90-day strategic review, as well as commissions on higher new ACV sales. As a result of the lower revenue and higher operating costs, adjusted EBITDA for the second quarter was a loss of $9.7 million versus a gain of $4.4 million in Q2 of 2013. On the bottom line, our non-GAAP net loss in the quarter was $7.3 million or $0.09 per share compared to net income of $1.5 million or $0.02 per share in Q2 2013.

Turning to a quick review of the balance sheet and cash flow metrics. DSOs in Q2 were 82 days, down from 87 last quarter. Overall, our cash flow from operations was down year-over-year to negative $2.1 million, reflecting the lower profitability in the quarter. Capital expenditures were $4.3 million, including approximately $600,000 of capitalized development cost, resulting in negative free cash flow of $6.4 million after adjusting for exchange rates. We ended the quarter with $240 million of cash and equivalents.

Turning now to guidance. At a high level, we are seeing a growing decline in our revenue this year attributable to the following factors: Inconsistent performance in the installed base of our Managed Services business globally; relatively light new additions of ACV in 2013 and Q1; slow ramping of the business that was signed; and finally, the consistent churn in ACV over the 4 quarters.

As Mike outlined, the challenges we face require investment to return each business to a path to profit -- to revenue growth and enhanced profitability. At the same time, however, given the reduction we are experiencing in our top line, we must lower costs to better reflect our revenue profile. There are many activities underway to rightsize our business and reduce our run rate costs exiting this year.

We are acting swiftly and decisively to remove costs, but we will not be able to remove costs fast enough to compensate for the decline in our revenue in 2014. We are focused instead on taking actions that will rightsize our business for the medium term and create the capacity to invest in our business for profitable growth over the long term. As such, we have undertaken 3 primary initiatives to improve our margins. First, we are looking to decrease cost in those areas where we have made investments in anticipation of higher revenues and where reducing those expenses will not have a direct impact on customer-facing activity. We are moving quickly to reduce our back-office and infrastructure costs, decreasing discretionary spend for non-customer-facing activities, and improving our operating efficiency to enable us to support the business with better economies of scale. While this is an area where we can move quickly, we expect this to represent less than 25% of the cost improvements we need to effect in our business.

Second, in our strategic review, we identified areas in each business unit where our spend levels and key metrics are not consistent with industry benchmarks, including cost to acquire and deliver new business. We will be looking for ways to improve these metrics over the next 6 to 12 months through both cost reductions and process improvement. More specifically, this initiative includes improving the process of scoping statements of work on new product deployment, to reduce our cost to implement and deliver, and to drive significantly higher margins in our SaaS business unit. As professional services alone has grown to represent close to $15 million dollars in annual spend, this is a key area of focus for us in the short to medium term.

Third, and most critically, we need to invest in our Managed Services business in order to improve our revenue performance and reduce our cost to serve across all customer engagements. Mike already mentioned several investment areas. But the return on these investments will likely not be apparent until well into 2015. In the near term, however, we will evaluate our current engagements to confirm that through improved operations, we can ensure both our profitability, as well as our ability to deliver to our customers' highest satisfaction.

As Mike noted, our outlook has changed considerably in just 180 days. We are adjusting to these changes with the necessary investment to drive ServiceSource back to profitable growth while recognizing the importance of preserving shareholder capital and reducing costs to better match our lower revenue forecast. In light of the actions we're taking to decrease our operating expenses and improve our gross margins, we're providing detailed guidance for Q3, but we'll limit our update on financials for the full year as we work through the impact of all of these changes to our business.

I'll now go into specifics on guidance for Q3. We expect consolidated revenue to be in the range of $58.5 million to $62.5 million on a non-GAAP basis, reflecting a decrease of roughly 6% to 12% from Q3 of 2013. Because we are unable to adjust our cost base on pace with the decline of revenue and our continued investments in our new product deployment, we expect our consolidated non-GAAP gross margins to be in the range of 20% to 23% in the third quarter. We expect operating expenses in Q3 to remain roughly flat to prior quarter, resulting in adjusted EBITDA loss of $15 million to $18 million for the quarter. This assumes capitalization of our R&D of approximately $600,000 similar to Q2, and includes an early estimate of the severance and third-party consulting charges that we'll incur as we restructure parts of the business. We forecast non-GAAP net loss of $10 million to $12 million or negative $0.12 to $0.14 per share. This assumes a basic share count of 83 million shares and a normalized tax rate of 40%. Finally, given the investment required to take costs out of the business and the lower revenue outlook, we currently forecast negative free cash flow in the quarter of $20 million to $24 million.

On a segment basis, we currently forecast Managed Services revenue of $51 million to $54 million in the quarter, reflecting a decline of 13% to 18% year-over-year and non-GAAP gross margins of 19% to 21%. For our SaaS business, we expect subscription revenue in the range of $7.5 million to $8.5 million, up 113% to 141% year-on-year, with non-GAAP gross margins of approximately 80%.

We expect revenue to be up quarter-to-quarter due to the new business signed in Q2, offset by the reduction in some of our subscription contracts related to our early product deployment. Professional services cost will increase to approximately $4 million in the quarter, as we continue the migration to our new platform and bring new customers live on Renew. However, we anticipate recognizing revenue of only approximately $100,000 in the quarter, which will continue to put pressure on our overall Cloud & Business intelligence gross margin.

As I mentioned, because of the series of actions we're taking across the business, we will not update full year guidance other than to confirm that revenue will be meaningfully lower than the guidance we gave previously, given the miss to Q2 revenue, the downward guidance I just gave to Q3 and the reductions in revenue we may incur as we move through our restructuring activities. Accordingly, gross margin, EBITDA and free cash flow will also be lower than our prior guidance as any cost-cutting activities we undertake now will have limited impact on the profitability in the near term and will likely have an associated cost. As we reduce cost for some of the actions we have underway, we believe we will end the year having consumed approximately 15% of our starting cash balance, excluding the capital used for the acquisition of Scout, but we'll end on a path to significantly lower cash burn in 2015.

In summary, 2014 will clearly not generate the results we anticipated as we came into the year. However, we are taking the actions we believe will put us in a stronger position for 2015 and beyond and will enable the company to grow more rapidly and profitably going forward.

And with that, I'd like to open the line for Q&A.

Question-and-Answer Session


[Operator Instructions] Our first question comes from the line of Jennifer Lowe from Morgan Stanley.

Jennifer Swanson Lowe - Morgan Stanley, Research Division

I'm going to jump into the strategic -- the outcome of the strategic review in the SaaS, but maybe before we get into that, I just wanted to quickly touch on -- I think, earlier in the comments, there was a couple of remarks, one, about some contracts in the Managed Services business that were taken in-house; and then, two, I think there's also comment around reduction in scope a little bit for some of the subscription contracts that had been signed a while back. So I just wanted to drill into those 2 quickly to better understand some of the dynamics there and whether that's tied to sort of uncertainty around the -- what the strategic review outcome would be or if there's other factors in play there that we should be thinking about.

Ashley Fieglein Johnson

Jennifer, thanks for the questions. Primarily, as we've talked about in the past, on ACV churn, typically we're not losing to competitive situations but rather a customer making the decision to pull the operations back in-house and away from ServiceSource. And so that's -- and as I mentioned, the last 2 quarters have been in line with our annualized expectations of a 90% retention rate. So -- and we had talked about previously that internationally, since it's a smaller book of business, when that happens, it has a large impact. So that's what that referenced. In terms of the reductions in scope for subscription contracts, those are primarily related to some of the earlier deployment of Renew OnDemand where we've scoped back with the customer, the deployment, and it's a small handful.

Jennifer Swanson Lowe - Morgan Stanley, Research Division

Great. And then, I understand sort of the reluctance to commit to a timeline on some of the realignment that needs to happen currently, but maybe just a couple questions on that. One, has any of this started yet? Or does the clock effectively start today on getting people sorted into new roles potentially? And then two, and related to that, as you think about some of the components that are involved with breaking the sales force into 2 and getting them trained appropriately in the field. That just as a first step, is that something that's sort of mapped out in terms of the timeline on that specific action? Or is that sort of open ended in terms of when roles will actually get assigned and people will be out productive in the field along with the new lines of alignment?

Michael A. Smerklo

Yes, Jen, it's Mike. I would say that we have a massive sense of urgency, obviously, given what we've talked about financially. We need to make impact change as quickly as possible. We also acknowledge it's a huge transition, so what I would say is we started a strategic review 90 days ago and just to give you more color, it has been very comprehensive. We've done everything from looking at what the real root cause analysis are to our challenges. We started with a belief that it was showing up in go-to market. What we revealed was much more significant, as we talked about. We also did competitive and a market-sizing assessment. We've done a full benchmarking of the businesses. We developed a path forward, and we've done high-level org design all in the last 90 days. We've also gone through this restructuring plan. We've done -- began to communicate it internally. We've developed milestones and metrics for the plan. We've also engaged a professional project manager and a PMO firm to help us through this change. In terms of the org changes, we have begun to announce them and communicate them at the highest level immediately. We've also begun in terms of cost rationalization as quickly as we can. We've launched the president -- the search for the president of Managed Services and made some other org changes. So we're moving at a swift pace or as swift as possible and really the next 90 days, about implementation across the board. To your other question though, on the sales part, one of the things that we're mindful of is this isn't as simple as just saying, hey, we're going to have 2 sales force and you're on Team A or Team B. The complications come in to how do we have unique value propositions that are tied to each selling motion, how do we have a rework of the value statements and the contractual and statement of work we mentioned a couple of times. And then, working through rules of engagement between the 2 sales forces. So that's going to take some time. What we commented on is that we will run the teams jointly through Q3 and into Q4 as not to disrupt any customer-facing or ACV acquisition activities. We're just going to try and start moving the new relationships into 1 of the 2 buckets. So I would expect the ultimate goal here is to do as much as we can, certainly on the cost side with a massive sense of urgency, and then look on the go-to market and customer-facing side to implement the changes we can immediately, but really start to look to begin the new year with all of that in line from top to bottom. So that's the framework we're working on, but there's no shortage of urgency across the board here.


Our next question comes from the line of Scott Berg from Northland Capital.

Scott R. Berg - Northland Capital Markets, Research Division

Mike and Ashley, several questions here for you. Let's start off with the lack of -- or the underperformance of the Managed Service revenue in the quarter. Can you talk about, was that purely because of lower close rates or was it a combination of other items like you mentioned, maybe a customer pulling some business in-house during the quarter?

Michael A. Smerklo

Yes, Scott, what we've really seen on the Managed Services business, it's interesting, I guess, if there's any good news here, which is hard to find, we've looked at the performance in the quarter as also part of the overall market assessment. We're not seeing a major change in the competitive dynamics, if you will, that would impact close rates. So in some regards, I struggle to call that good news. What the reality means is that it's internal execution. We saw areas where we just didn't close the business on time, the level that we had expected or had historically and we also saw other inefficiencies in the business. So some of this comes from the ACV additions in 2013 and Q1. Some of it comes from ramping new business and churn, but I would say the bigger part of the miss really came from our own internal performance, us not executing at the level that we know we can and that we've done historically. That's really driving the miss and obviously, have been putting pressure on the rest of the year in Managed Services.

Scott R. Berg - Northland Capital Markets, Research Division

Then, can you help us understand the delta between when you gave guidance in end of April or early May relative to where the quarter came in at? Because my assumption was, obviously, you'd already seen some issues in the execution of that business in Q1, and I thought the guidance was kind of a worst case scenario, kind of using those -- the execution in Q1 as kind of the new baseline. What's the delta between when you gave that guidance and what was reported in the quarter?

Ashley Fieglein Johnson

Really, Scott, it was just a further deterioration in the performance as opposed to a stabilization or even improvement that we, frankly, expected to see just coming into the quarter and having identified some of the issues, believing that we could at least stabilize it. And the fact of the matter is the underinvestment that the operations have had over these past several years means that we're not going to be able to brute force our way out of this.

Scott R. Berg - Northland Capital Markets, Research Division

Okay. I also saw the 8-K release that Jay Ackerman is leaving the organization. I guess, can you talk about why he left? Was it his own decision or was that a higher-level decision by you all? And then, what does that mean for the sales teams moving forward? It sounds like there's going to be separate teams, but there's -- there'll be no one single head of sales anymore, it sounds like.

Michael A. Smerklo

Yes. So first of all, Jay's had an incredible valuable -- value to our organization, and we're working through this in a mutually professional way. What the result of this is -- of this whole strategy and the whole leadership team was involved, including members like Jay that will -- that were impacted by it, but we worked on this together and said what's the best path forward and came up with this restructuring plan across the 5 components I measured, the first one being that we really moved to separate business units. What that means then is, there are a handful of functions that were global and span both business units as they were before, that simply don't have a place in the new organization structure. So in cases like that, we're working through a very measured transition and in doing so in a mutually agreeable time frame. So I want to make sure that everyone understands that this is done with some folks that have had huge impact for us, individuals like Jay have done great work for us over multiple years, but when you move to a 2-business unit model, where there's roles that were across both in global roles, we just don't have a need for them anymore. We will move forward with the approach to have separate sales, separate solution-based marketing and separate customer, what we called customer success or customer-facing customer account management roles within each business unit. And so, the only thing that will be shared at the corporate level will be the 4 functions that I mentioned in the script. Everything else will be distributed to the business unit.

Scott R. Berg - Northland Capital Markets, Research Division

Okay. And then last question for me, Ashley, on the cash burn in the quarter. Free cash flow burn of $20 million to $24 million sounds quite high even with your recent execution issues. Can you maybe detail a little bit more, is it purely just the carried run rates of cost in the last quarter relative to the new revenues? Or is there going to be, I don't know, higher level of severance costs maybe then, what I'm thinking at the present time? Just trying to understand how we get to that $20-plus million because it seems like a big difference in where you've been recently.

Ashley Fieglein Johnson

It is a big difference. And it relates to the fact that we have run rate costs that we can't take out of the business as quickly as we're seeing the revenue come down, and we are obviously moving quickly to realign our cost structure, as I detailed earlier. But the fact of the matter is, in Q3, we're not going to be able to cut costs quickly enough to counteract the decline in revenue, and that's the impact on cash. Q3 is typically a tough quarter for collections anyway given our international business. And so, that compounds the matter.


Our next question comes from the line of Ed Maguire from CLSA.

Edward Maguire - CLSA Limited, Research Division

I was wondering in your -- it's obviously a lot of information to sort through that you've gone through over the last 90 days, but what have you learned about the quality of contracts in your underlying Managed Services business. Was there -- have you discovered anything about some of the prior MSS business that you've done that was a disconnect from what you're believing before? And I guess, that leads to the question whether you were -- whether the SaaS business, in effect, was cannibalizing itself? Would just be curious as to -- because there had been -- I know you, in the past, have had -- there had been some issues with just the nature of the underlying business that you guys were executing against. And sometimes you've had some changes in the customers -- your client's mix as well. So I'd be curious to get any color on that.

Michael A. Smerklo

Yes, it's -- and you hit upon what I'd say the progression in the last 90 days. We came into it realizing there was a slowdown in go-to market and challenging in our customer messaging. When we dug deeper and really did a root cause and discovered as running these 2 businesses in a hybrid fashion, not just selling a hybrid solution, but running in a hybrid fashion, really became clear and speaks to what you're alluding to. The root cause, if you really dig in -- and this shows up in gross margins, it shows up in cash burn expectations that Ashley had out is -- it's really three-fold. One, we have this underinvestment Managed Services, we've talked about it in the past but it really has put our cost to serve at a much higher rate -- higher level than it should be. So when we were signing new managed service customers, our expectations around profitability may have been off in our modeling because we had historically been able to drive cost out of Managed Service at a pretty aggressive rate. When you take 3 years off from investment, that clearly is going to take a pause and we've got to begin an aggressive process, it's 1 of the 5 steps I laid out, to get Managed Services back on track. So I think that's the first aspect of it. But tied into that, when we went forward with this market message, it became very clear that we were putting, because we're trying to get the SaaS business off the ground, an unintended consequence was that we commoditized the market message for the BPO business. And what that meant is we were putting less emphasis on our core value proposition there, so we were signing up for maybe higher levels of performance or not defining scope as well as we should. So therefore, we've had headcount go up or it turned into a headcount play as we've seen headcount go up and cost to serve go up trying to live up to unrealistic expectations. And then, the third one is just making sure, as we've gone through this transition, because we've had vagueness around this, as we've called it out several times, a statement of work, without these clear definitions, we've had to throw bodies at things to bridge the gap in both professional and managed services. And so, it really is -- you asked a super question, but the core issue is deeper than go-to market, it's the 3 things I highlighted. And I think why, as disappointing as it is to be here today, the plan forward is so comprehensive is because it really takes and attacks these root causes that I've just discussed.

Edward Maguire - CLSA Limited, Research Division

Great. And just when you look at -- attacking the cost structure here, I mean, it sounds like you feel that the underinvestment in technology has really been at the core. And I know that every situation is different, but I mean do you feel that, that it's going to be technology that's going to allow you to really take cost, that investing is going to allow you to create more process automation and efficiency? Or was there an organizational issue where you just may not have had the right people in the right roles doing the right things?

Michael A. Smerklo

It's a little bit of both. And one of the things that you'll hear us saying more overtly than we have in the past, is the term BPO or business process outsourcing, that's what the Managed Service business is. We know how to run that business because we've done it successfully for a long period of time. Unfortunately, with these businesses, as I know, because 12 years here, is that they are incredibly detail-oriented, and there is no one single solution. It really does come down to the value proposition, how you manage your workforce, not only in what the tools you give them, but where they sit and how you continue to source talent, how you manage processes, not just are they automated but are they repeatable and do they show up specifically in statement of work? Are you able to provide -- automate as much as you can? And then, do you have the right contracting structure, meaning do you have very tight statement of works, so that if there is change orders or change in the customer environment, you're able to recoup the cost for it. That unfortunately -- and then, of course, leadership, too. So those are the cornerstones of the BPO business. Admittedly, we've lost our way over the last couple of years without investment. And that's what we're setting about to change. I believe if there's good news, we know what to do. The bad news is, none of those things can be changed overnight. We're in the market for new leadership. I think we're going to get some great additions there. But at the end of the day, you can't take 3 years off and expect to turn that around in short order. So it's going to take time.


Our next question comes from the line of Albert Tukin [ph] from William Blair.

Bhavan Suri - William Blair & Company L.L.C., Research Division

It's Bhavan here. So just following up on Ed's questions here. When you look at the gross margin of Managed Services business, even prior to the launch of Renew or even conversations around Renew, those have trended down. And then, Mike you spoke a little bit about commoditization. I know you're talking about messaging. But it sounds like there's sort of commoditization on the services side. And I guess, I'm just trying to contrast that with your comment that there's no competition. So help me sort of understand what was going -- gross margin coming down before you started focusing on Renew 3 years ago, 4 years ago, and then sort of comment around commoditization.

Ashley Fieglein Johnson

Thanks, Bhavan. In terms of prior to the launch of the Renew strategy, we had one customer, frankly, back in those days some that operated at higher gross margins because, frankly, we did a different array of services for them. And when that customer was acquired, that impacted our overall gross margins. So that's the downward trend that you see before the launch of the Renew strategy, and it was really a separate issue that I'd kind of put to one side. Overall, though, as you said, the reason for moving into the market with Renew was a customer-driven strategy, customers asking for this and also a business model strategy of saying we wanted to have the ability to offer 2 different ways of solving this recurring revenue management problem and that SaaS business should bring higher margins as well. So you're right in that it was a downward trend, but I'd put that in a separate category, unrelated to what Mike was referring to on the commoditization of the message. So Mike, do you want to take the second point?

Michael A. Smerklo

Yes, Bhavan, if you think about it this way, we were going out historically with a bundled message. It was black box but we were able to talk about a business outcome and talk about multiple facets of that. If you go back and look at when we went public NRS 1, we had a very comprehensive story around our Managed Services. The good news is, that those core tenets and value proposition are still in place. But when I look at our over rotation, that's what I'll call it, in the last 18 months, we started to talk about Renew, which is a phenomenal SaaS product, but when we started to move -- the pendulum swung all the way over to Renew, Renew, Renew, what you are left with in the unbundling, as an unintended consequence, is a more of a bodies for hire mentality, and that's never been our tenet. We've never hung our hat on that. We've always talked about it being comprehensive, but that's what started to show up in our pricing margin. And that's -- when I think about the future state and while I am -- I believe this is the right path for the business is, you can get back to a comprehensive value proposition for the Managed Services business and you can let the technology solution be sold in a stand-alone fashion and you can let buyers line up for what works better for their business. But that does not mean -- in the corporate message is the same, but you do not go-to market with à la carte approach, which we've done in the past.

Bhavan Suri - William Blair & Company L.L.C., Research Division

And then, when you look at the core platform, it obviously supports the Managed Services business and then sort of your SaaS, pure SaaS customers and hopefully, there's cross-sell or whatever. But when you look about the Managed Services business still running on Renew, how do you guys, in the go forward sort of reorg, think about managing that? Because obviously, your SaaS customer want feature functionality, but obviously running a lot of customers on the Managed Services platforms drives a lot of enhancements too. How does that work in the new organization and sort of how do you deal with the pull and pull -- the push and pull between those 2 sort of -- demands from those 2 organizations? How are you guys thinking about that?

Michael A. Smerklo

It's a super question. What we're thinking about, and this is one of the details to work through, you've just hit upon one of the more of the complexities of the go-forward plan. But I believe the best way to solve this is, is for the SaaS division, Cloud & Business Intelligence, to look at Managed Services as it's, one of or its largest customer. And so you define -- the way you interact between the business units is similar to how you'd interact with an external customer. That means you have to find scope. You have ProServ, you have UAT, you have different signoffs for the Managed Service like you would for any other customer, and you drive each other in a supportive way. But I think by having a commercial relationship or commercial approach between the 2, you'll get the best of both. And I think it's very important over time for Managed Services to be able to highlight that they use Renew, but they're going to do a whole host of things to add on to it to differentiate the value proposition, and similarly to have the SaaS division to be able to sell it on a standalone basis. So that's one of the complexities we're working through in the next 2 quarters.

Bhavan Suri - William Blair & Company L.L.C., Research Division

One quick one on professional services. Obviously, the professional services business has been a little bit of a challenging business and as you look at the core of what you do, there's a significant portion of professional services that is involved in taking the various data elements contracts -- contracts, contract databases, renewals, CRM systems, whatever and integrating that into the Managed Services business and into Renew. And so where do you think professional services falls there? Where do you think the pricing for that -- because remember when you brought sort of some of the new sales structures over about 2 years ago, you guys didn't charge for professional services and you started charging for professional services, which is a positive. But help us understand how that looks going forward, too, given the split of the businesses?

Michael A. Smerklo

Yes, let me -- I'll give you the high-level org component and then add on to the financial component if necessary. This is one more example of where this is all gotten muddied below the go-to market and the value proposition line. What we will set up for is have ProServ be just like any other SaaS business, have it charge market rates for -- to bring onboard customers and integrate them as need be. That's part of Cloud & Business Intelligence, and that has commercial requirements like you would for a SaaS business at that size. On the flip side, as you know, BPO businesses have something called a PMO or a customer onboarding component. And we are reestablishing that in the BPO business and that is -- takes everything from changed management, staffing, location, training, as part of the BPO offering. But the biggest point is, you draw the line between what the customer is asking you to do. In a BPO business, you're trying to get the customer live as quickly as possible and handle change management, that's PMO. On the SaaS side, that's about technology migrations, customization as need be and integration, that's professional services and we need to find a way to charge market rates for that as the product becomes more mature.

Ashley Fieglein Johnson

Yes, just following on, on that, Bhavan. If you think about it, when you're doing a technical systems implementation, you're defining what's included in that and what's not included in that in a very specific way. So what is the environment look like that you're integrating to, what are the requirements then and the hours needed to perform that work and the scope is very bound. On a Managed Services side, it's really more about managing the transfer of the activity from inside the 4 walls of the company over to ServiceSource, and that's a different set of activities. If you start bundling in the outcome of what's going to happen when Managed Services is up and running into the professional services engagement, that's when you start to get very unclear about actually what's captive inside that statement of work and what's really outside of the scope of that. And that's the crossover between those 2 functions is really where you started to see significant scope creep, therefore, a challenge for us on cost management, and even beyond that, just a challenge on managing customer expectations and ultimately, customer sat. So that is [indiscernible] just we have.

Bhavan Suri - William Blair & Company L.L.C., Research Division

So having run, and you guys know my background, I've run a professional services business and a software business. But I guess, at a high level strategically, so doesn't it even make sense to keep the 2 businesses together?

Michael A. Smerklo

You mean, from a corporate perspective?

Bhavan Suri - William Blair & Company L.L.C., Research Division


Michael A. Smerklo

I think there's some really good news. As I mentioned, this review was exhaustive and probably the most positive -- again, it is not a day to be talking about positives other than the plan forward and what we learned around the market. The assessment helped us understand that there's still is a big need for recurring revenue management solutions. The importance of what we do and the growth we're going to need is only going up. So that's good news. It also helped validate that there are really, as we put up on the slides, there are 2 different types of buyers. There's an outcome buyer, and there's a technology buyer. Our belief is that we can serve both, but we just have to be more distinct in it. And we do think there's a real benefit by having a thin line, if you will, at the corporate layer, and that will be shared functions that don't add double cost, but HR, finance, corporate IT, and G&A, and then corporate messaging and marketing. So I think, there is a real benefit to having both businesses. The key, though, is lining up to what the buyer's needs are and then having every aspect of your delivery, say it again, every aspect of your delivery lined up to what you agreed with the customer. And that's where we, I think, had really lost our way.


[Operator Instructions] And this does conclude the question-and-answer session of today's program. I'd like to hand the program back for any further remarks.

Michael A. Smerklo

Thanks, everyone. We appreciate the time today, and we will look forward to answer any questions as they come up in the follow-up sessions. Thank you.


Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.

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