Interactive Intelligence Group's (ININ) CEO Don Brown on Q2 2014 Results - Earnings Call Transcript

Interactive Intelligence Group, Inc. (NASDAQ:ININ)

Q2 2014 Earnings Conference Call

August 4, 2014 4:30 PM ET

Executives

Steve Head – CFO, SVP, Finance and Administration, Secretary and Treasurer

Don Brown – Chairman, President and CEO

Analysts

Shyam Patil – Wedbush Securities, Inc.

Tavis McCourt – Raymond James & Associates, Inc.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Mike Latimore – Northland Capital

Craig Nankervis- First Analysis Securities Corp.

Operator

Good day, ladies and gentlemen, and welcome to Interactive Intelligence Second Quarter Earnings Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator instructions) As a reminder, this conference is being recorded. I would now like to introduce your host for today’s conference, Chief Financial Officer, Steve Head. Please go ahead.

Steve Head

Thank you. Good afternoon and thank you for joining us today to review Interactive Intelligence Second Quarter 2014 Financial Results. With me on the call today is Don Brown, our Chairman of the Board, President and CEO.

Don will begin with a high-level review of our second quarter performance in addition to providing an update on our key initiatives. I will then review our second quarter financial results in more detail and provide the financial outlook before turning it back over to Don for closing remarks. We will then open the call for questions.

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

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

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

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

Don Brown

Thanks, Steve, and thanks to everyone for joining us on the call today to review our second quarter results. As we announced a few weeks ago, our second quarter results fell short of our original expectations due to delays in on premises orders primarily in North America as well as revenue deferrals from two sizable contracts signed in prior periods.

Despite the second quarter underperformance in our on premises orders, we were pleased with the ongoing strong demand for our cloud-based solutions evidenced by the 69% year-over-year growth in cloud-based orders excluding the largest contract in the company’s history that we booked during the second quarter of last year.

In addition, cloud-based revenues increased 77% year-over-year and accounted for 31% of recurring revenues, up from 22% of recurring revenues in the second quarter of 2013. We continue to be very pleased with rapid growth on our cloud-based revenue since it has a positive impact on the increase in scale of our overall recurring revenue and visibility into our business.

We believe that Interactive Intelligence is well positioned to maintain momentum in the cloud market which continues to be the highest growth segment of our business especially given the recent launch of Pure Cloud.

As a reminder, this is our next-generation effort that leverages modern open source technologies in the Amazon Web Services as the deployment back end. Pure Cloud is a multi-tenant solution that is ultra easy to deploy and capable of handling the needs of both very large and very small customers. And it does all of this at a much lower operating cost.

This solution will also allow us to enter the growing market for cloud-based unified communications and provides another option for contact center automation. I’ll add some details later, but Pure Cloud is on track to be available throughout the US in the fourth quarter of this year with service initiation in other geographies starting early next year.

Taking a look at some of the summary level statistics and financials for the second quarter, total orders excluding the largest contract in the company’s history increased 12% year-over-year with cloud-based orders increasing 69% and representing approximately 52% of total orders. Including the large contract, total orders decreased 38% year-over-year.

We won 70 new customers during the quarter compared to 89 in the year-ago quarter. We also had 39 orders over a quarter of a million dollars which included 10 orders over $1 million. This compared to 43 orders over a quarter of million dollars which include 13 orders over $1 million during the second quarter of 2013.

As we mentioned on the call a few weeks ago, we’re continuing to learn that as we go up marketing to these very large deals, they just take longer to complete than have been our experience previously given the inherently unpredictable approval process at this large corporation.

The average dollar amounts of new cloud and premises based customer orders were $474,000 and $281,000 respectively in the second quarter of 2014, up from $427,000 and $221,000 during the same period last year.

The average dollar amount during the second quarter of 2013 does not include the large contract since it was from an existing customer. Our second quarter non-GAAP revenues were $79.8 million up 5% compared to the same period last year, but below our original expectations due to the lower-than expected products revenue – on premises revenue I have mentioned earlier.

As a result non-GAAP operating loss for the second quarter was $6.6 million. As we’ve stated in the past, there’s potential for variability in our reported results on a quarter-to-quarter basis considering that we have a hybrid cloud premises based business model in addition to the fact that we can close a number of sizable deals at any given quarter.

The ongoing growth in our cloud-related business continues to result in revenues being deferred to future quarters which contributed to the growth of our un-build future cloud revenue.

During the second quarter, our overall deferred revenue and un-build contracts increased 38% on a year-over-year basis to $336.7 million. As we continue to execute on our strategy to improve the long-term financial profile of the company, recurring revenue for the second quarter which includes both maintenance contracts and cloud-based revenues increased 27% year-over-year and was primarily driven by the 75% growth in cloud-based revenues.

As a result, recurring revenue increased through 56% of total revenues in Q2, up from 46% during the same period last year.

From a geographic perspective, we saw solid customer demand and orders across the Americas, Europe and Australia. As I mentioned earlier, North America was impacted by the delays in on-premises orders. As we’ve stated in the past, we’ve seen similar quarter-to-quarter fluctuations across geographies over the past six quarters and expect to see growth in all regions for the full year 2014.

What is most meaningful from our perspective, our long-term trends and the pace of pipeline activity which continue to be very strong. From an industry perspective, we continue to be the only vendor with a proven scalability, reliability and functionality in a cloud offering and with the launch of Pure Cloud, our multi-tenant cloud-based solution, we believe that our significant lead time advantage will be extended.

We officially launched Pure Cloud a suite of four different cloud-based application services in early June at Interactions 2014, our annual global customer and partner conference.

The first service which we’re already deploying at selected customers is called Pure Cloud Directory. It’s a rich corporate directory that makes available deep user profile content such as skills, work experience and location. It provides bidirectional synchronization with popular systems such as Active Directory, Exchange, Workday, SharePoint and Salesforce.

Pure Cloud Directory also includes a sophisticated Google type search allowing the usage of free formed terms to look for the right employee at the right time. We will also be adding real-time geo-location so that you can use an employee’s mobile device or web browser, you can know where they are and then be able to search on that information.

We have native mobile clients for IOS, Android and Windows Phone 8 giving users access to the complete organizational directory at all times. As a reminder, our recent acquisition of OrgSpan brought this new set of foundational components to Interactive Intelligence and further solidifies our leading position in the communications market.

The second service is called Pure Cloud Social Customer Service or SCS for short. SCS reinvents customer service by allowing customers to see the agents available, view detailed information about them and then choose the one with whom they want to interact and the channel of that interaction.

The third service is called Pure Cloud Unified Communications which offers IP PBX, unified messaging, [indiscernible] and video. It also includes enterprise grade instant messaging with strong security, granular administration along with file sharing and chat rooms for multi-user collaboration.

The fourth service is Pure Cloud Contact Center which is a comprehensive solution for inbound and outbound contact centers with speech enabled IVR, call recording, web chat, quality management and sophisticated skills based routing.

We expect to start deploying Pure Cloud SCS, unified communications and contact center in the fourth quarter.

Our aim overall for Pure Cloud is pretty ambitious, making it possible for organizations of anywhere from 100 to 100,000 to take advantage of the cloud for communications, collaboration and customer engagement. Pure Cloud was designed to offer this sort of security, scalability and granular administration required by large organizations. We already have a Pure Cloud pipeline of over $50 million and haven’t even formally launched our sales effort.

Pure Cloud was designed for rapid deployment and we expect that part of our business to ramp quickly beginning in the fourth quarter of this year. We believe that with the combination of Pure Cloud, our mature premises-based CIC product and our single tenant CaaS [ph] service, we have an unparalleled set of communication offerings.

We’re also very excited about our recently announced partnership with West Interactive. West is an elite partner which allows them to obtain our most extensive sales, technical and support certifications.

Given that West is one of the largest hosted unified communications providers, we are optimistic that they will become an important reseller channel for our cloud-based solutions.

We are also very pleased to, again, be awarded North America’s Contact Center Systems Company of the Year Award by Frost and Sullivan. In addition, our CIC product was named among Network World’s fave waves, a list of favorite products voted on by IT professionals. We’ve been recognized many times over the years and view this most recent recognition as further confirmation of the company’s ongoing leadership especially in the cloud, we continue to grow our business at a pace above the market.

So in summary, while our results for this particular quarter were lower than we originally expected, I remain very confident in our future due to strong ongoing demand for our solution, a growing pipeline of opportunities, our commitment to innovation and our ability to execute our comprehensive plan for addressing the opportunity of the cloud.

With that, let me turn the call back over to Steve.

Steve Head

Thanks, Don. I will first provide more details in the Company’s second quarter financial results and then conclude by providing our financial guidance for the third quarter in full year of 2014.

Now beginning with the P&L as Don mentioned in his remarks we reported non-GAAP revenues as $79.8 million, up 5% compared to the second quarter of last year. The primary driver of our total revenue growth continued to be our recurring revenue sources which include both maintenance contracts and subscriptions.

Our non-GAAP recurring revenue was $44.6 million during the quarter representing 56% of total quarter revenue and was up 27% year-over-year. The growth in recurring revenue was driven by the rapid growth of our subscription revenues which increased 77% year-over-year to $13.9 million along with increases in maintenance and support resulting from the increasing installed based to bond [ph] premises customers.

As a reminder during the first quarter of 2014, our subscription revenue did benefit from higher seasonal usage from a large customer. Non-GAAP product revenues totaled $21.5 million representing 27% of revenue and declined 23% on a year-over-year basis primary due to the delay in large premises orders and not recognizing revenue from two large contracts.

Specifically, there were two separate orders of approximately $2 million each one of which is a current customer and one for which we have been recognizing product revenues overtime. Given the expansion of professional services for that customer in the second quarter and the fact that these services and license agreement are tied together, it resulted in recalibration of the amount of revenues we were able to recognize in the second quarter.

As we highlighted on the call a few weeks ago, we view the increase in business as a positive although the additional professional services resulted in the changed revenue recognition.

As we have mentioned in the past, it only takes a handful of orders to change the mix of premises based and versus cloud. We continue to expect to see a level of quarterly variability in both the growth and mix of our revenues going forward.

Based on the first half results and sales forecast, we expect on premises orders in 2014 to decline about 10% compared to 2013 full year. These orders were down 17% for the second quarter and contributed to the lower product revenues recognized compared to the prior year.

The average new customer order increased 30% to $353,000 in the second quarter of 2014 from $272,000 in the second quarter of last year. Services revenues were $13.7 million during the second quarter consistent with the same period last year in the first quarter of 2014.

Professional service revenues associated with our cloud-based deployments are generally lower than our premises-based deployments. During the second quarter, our partners generated 27% of orders compared to 23% in the second quarter of last year.

Geographically for the quarter, the Americas provided 67% of total orders while EMEA was 26% and Asia Pacific was 7%. Non-GAAP gross margin was 58.3% in the second quarter compared to 64.9% during the same period last year. Non-GAAP product gross margin for the second quarter was 69.6% compared to 74.2% in the second quarter of 2013.

The product margin at any quarter is based on the mix of hardware and software that is recognized as revenue in that quarter. Non-GAAP recurring gross margin for the second quarter was 65.1% compared to 72.1% last year. This year-over-year decline was due to our cloud revenue growth and the lower current margins on cloud operations.

Non-GAAP services revenue gross margin was 18.2% compared to 26.1% during the same period last year. This year-over-year decline was due to the continued investment and services personnel. Non-GAAP operating loss which excludes stock-based compensation expense, purchase accounting adjustments and certain acquisition expenses was $6.6 million in the second quarter of 2014 and below our original expectations due to the lower than anticipated product revenues.

Non-GAAP net loss for the second quarter was $3.7 million or $0.18 per share based on $20.9 million shares outstanding which compares to net income of $3.4 million or $0.16 per diluted share for the second quarter last year.

To illustrate how the delayed revenue recognition and mix can affect reported earnings, if we have been able to recognize the revenue from the two large on premises contracts that I mentioned earlier, we would have reported a revenue increase of approximately 10% and a non-GAAP operating loss significantly closer to breakeven for the quarter.

Excluding the large order in the second quarter of 2013, we had 34% of our orders cloud based in that quarter which compares to 52% in the second quarter of 2014. So clearly the revenue recognition and makeshift in Q2 had a dramatic impact on both recognized revenues and reported operating results.

Providing summary level results on a GAAP basis, during the second quarter, GAAP operating loss was $11.5 million and GAAP net loss was $6.8 million or $0.33 per share. This compares to GAAP operating income of $800,000 and GAAP net income of $2.9 million or $0.14 per diluted share in the second quarter of 2013. Second quarter of 2013 included a one-time tax credit related to the treatment of foreign operations.

Returning to the balance sheet, as of June 30, 2014, we had $86 million of cash and investments compared to $104.9 million as of March 31, 2014. The decrease in cash during the second quarter is the result of using $1.4 million of cash for operating activities, $4.9 million for capital expenditures and $9.3 million related to the acquisition of OrgSpan. The company continues to be debt free.

Accounts receivable days sales outstanding at June 20, 2014 were 73 days which compares to 83 days last year and 80 days at the end of the first quarter of 2014.

Adjusted DSOs which take into account the increase in deferred revenues were 77 days. Total deferred revenue at June 30, 2014 were $111.9 million, an increase from $108.3 million as of June 30, 2013. As we continue to sign additional cloud-based contracts, we had built an amount of contracted-future revenue that is not recorded. This amount totaled $224.8 million as of June 30, 2014, up from $136 million as of June 30, 2013.

Deferred revenues and subscriptions totaled $336.7 million as of June 30, 2014, up 38% from $224 million one year ago. In regards to full year of 2014 guidance, given the shortfall in Q2 we now expect total orders to grow approximately 10% including the large order from last year are over 25% excluding that large order with cloud orders continuing to represent 55% to 60% of total orders. We believe that this continues to represent a solid forecast since it’s on top of 48% and 30% increases in total order growth during 2012 and 2013 respectively.

We now expect total revenues between $340 million and $345 million compared to our previous guidance range of $365 million to $370 million, an increase of about 8% year-over-year at midpoint of the range. This includes the expectation of recurring revenues to be over $180 million, an increase of over 20% year-over-year driven by approximately – by the approximate 65% increase in cloud-based revenue. Recurring revenues will represent approximately 53% of total revenue in 2014, up from 46% in 2013. We also expect service revenues to be consistent with 2013.

Given the lower than expected second quarter product orders we now expect product revenue to decline over 5% year-over-year and anticipate a full year 2014 non-GAAP operating loss of $12 million to $13 million, our non-GAAP EPS up $0.33 to $0.37 on 21 million diluted shares compared to our previous guidance of EPS earnings up $0.15 to $0.36. With regard to the third quarter of 2013, we are currently targeting revenue in the range of $83 million to $85 million, our year-over-year growth of 6% to 9%.

We expect the combination and timing of product orders and ongoing investments in our cloud-based business to lead to an expected non-GAAP operating loss of approximately $6 million. Given that it only takes a handful of orders to change the mix of on premise versus cloud, we continue to expect to see a level of variability in both the growth and mix of our revenues.

As we have discussed in the past there is a short-term impact from cloud-based orders because we do not recognize the revenue upfront which leads to the growth of recurring revenues longer term about lower near-term profitability. And now, I’ll turn the call back to Don for some closing comment.

Don Brown

Well, it’s increasingly clear that like the rest of IT, communications is moving to the cloud. We feel extremely well-positioned to take advantage of this trend. We anticipated it much earlier than our competitors when we launched our CaaS offering back in 2008. And in spite of the rapid success we gained from CaaS, we decided to make an even bigger bet three years ago when we initiated our Pure Cloud effort.

In 2013, we reached the point that half our orders came in the form of cloud subscriptions and renewing the 60% mark in 2014. Although this change has had its challenges, we think that it will be to the long-term benefit of our company and its shareholders.

Our plan is the following; one, to continue to sell and enhance our CIC product that has been widely recognized as the best on-premises contact center suite on the market. Although cloud delivery is clearly the wave of the future, we still encounter a number of organizations that prefer a traditional license software model.

Two, to continue to offer our CaaS cloud service that leverages CIC in a virtualized single-tenant form running out of our data centers around the world, and three, to rapidly ramp up Pure Cloud, our new multi-tenant suite of cloud services that cover the whole gamete of communications, collaboration, and customer engagement. We believe that Pure Cloud subscriptions will quickly represent the majority of our orders surpassing both CIC and CaaS in quarterly dollar volume by the end of 2015.

In order to develop and support these three deployment options we’d had to invest heavily which shows in our expense level. With the release of Pure Cloud, we’re at the point that we can start to realize the return on this investment.

We believe that Pure Cloud will be far more profitable than CaaS. That was our plan when we began the effort in 2011. We designed it to be quicker to deploy and easier to support. We believe that we will be able to realize gross margin in excess of 70% with Pure Cloud once it ramps up, approaching the gross margins of our CIC business and far exceeding the profitability of a virtualized single-tenant service such as CaaS.

Our plan is to flatten the expense curve and increasingly focus on improving profitability. We’ll start to see the financial effect in the second quarter of this year and especially as Pure Cloud sales ramp in 2015.

We are committed to continuing and even accelerating our move to become a cloud software company. We believe we have a significant competitive advantage especially with our Pure Cloud application suite at a time when communications will increasingly move to the cloud. Although this transition hurts our profitability in the short term we believe we can build a highly scalable and profitable business.

Although we haven’t completed our planning for 2015, we anticipate additional progress towards our goal of running our overall business at a gross margin in excess of 70%. And with that we’ll turn the call back over to the operator to start the Q&A session. Operator?

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes from Shyam Patil with Wedbush Securities. Your line is now open.

Shyam Patil – Wedbush Securities, Inc.

Hi, thank you. Steve, thanks for the comment of revenue growth would have been if you take into account the two deals that split. I was just curious on the cloud side, how do you feel like you did from a booking standpoint versus expectations? I know you had a tough call, but just relative to expectations, how do you think you did? And if you came in slightly below, if you did, what do you think were the reasons for that?

Steve Head

Well, I’ll get started and let Don can then add in. We were a little lighter than we expected. We have a very strong pipeline. And as we just talked about as we look at the rest of the year we see a very strong second half of the year relative to a year ago and so we still feel very good about the year. But clearly second quarter premises orders were lighter than we’d expected. And cloud orders were somewhat lighter.

Don Brown

Yes, as I think I said on the previous call that we had, we expected some larger cloud orders to come in. It took a little bit longer than expected. We’ve had at least two of those already closed this month and we’re expecting the other two to close within the next couple of weeks.

So, it isn’t as if we’re losing the business it just took a little bit longer than we expected to get in. And we’re just finding that the sales cycle runs a little bit longer on these deals. As we go up market they take – it’s just harder to predict exactly which quarter they’ll fall and unfortunately it makes our order pattern lumpier than we would like. But we think the overall trend remains very positive.

Shyam Patil – Wedbush Securities, Inc.

Okay. And just on the – on the second half of the year, Steve, what are you guys – what is that 10% order growth for the year translating to for the – for the second half order growth?

Steve Head

I think it’s about 25% for the second half year over year.

Shyam Patil – Wedbush Securities, Inc.

And is that – historically you talked about being the 20% or better order growth company you’re certainly guiding to that in the back half of the year, is that – is that the right way to think about the company going forward, not necessarily 25% but 20% or better?

Don Brown

Yes, we certainly – that’s our ambition to meet or exceed that number. That’s certainly what we’re trying to do. And we think that we’re in the position to continue to do that for the foreseeable future.

Shyam Patil – Wedbush Securities, Inc.

Okay, and Don, this is my last question, on the last call you talked about maybe leveraging the indirect channel a little bit more, even more focused on the mid-market deal. Can you maybe talk about that a little bit and where you are in that process and how long do you think it takes to kind of get to the optimal mix?

Don Brown

Well, I think we’re pretty far along with that especially with Pure Cloud. As I mentioned, Pure Cloud we designed for rapid deployment. And it’s a perfect partner application service. We are building a network of both referral and implementation partners and we think that it’s something that a channel can participate much more in than CaaS.

As a single-tenant virtualized instance of our CIC product, there’s just a lot of complexity around CaaS deployments that isn’t there with Pure Cloud. And we’re also designing Pure Cloud and intending to push more of the services responsibility to our partners. So they’ll have lots of opportunity to do the services the – our preference to concentrate on building that subscription volume, trying to just generate as many sales as we can and we’re more than happy to see our partners do the services.

Shyam Patil – Wedbush Securities, Inc.

Great. Thank you, guys.

Operator

And our next question comes from Tavis McCourt with Raymond James. Your line is now open.

Tavis McCourt – Raymond James & Associates, Inc.

Great. Thanks for taking my question. Don, just a follow-up on Pure Cloud and some of the metrics you mentioned, I think you said something about a $50 million and backlog or indications of orders. And I was wondering is that something we should see work into orders immediately once the services are commercially available orders [ph] over time?

And then secondly it seems like the scope of the features and functionality or applications that you’ll be providing on Broad Cloud – I mean on Pure Cloud is significantly greater that what you’ve done on CIC historically. And I’m wondering does that have to be strategically a big investment for you guys, what is it you see in the marketplace that allows you to move – I mean it almost looks like beyond core contact center into broader levels of communications? And how it will be structured or thinking of structuring just the recent channels in light of that? Thanks.

Don Brown

Yes, those are really good questions. Yes, I guess I would point out that even with CIC we’ve sold over the years into organizations that use us for their complete corporate communications. It’s really had been for companies for the most part who have used us in place of a PBX, but we’ve never really proactively gone after that broader unified communications market. We didn’t feel that we had some of the capabilities especially around mobile interfaces and non-voiced communication channels like instant messaging.

But with Pure Cloud we do. I mean we are partly – we largely designed it that way from the beginning but some of those capabilities came to us via the OrgSpan acquisition. And it just puts us in a position to go into organizations with a broader message that we can also take to a higher level within the organization. It’s a message that resonates up in the C-Suite the notion that you can choose one partner, one cloud partner who can provide everything you need across the spectrum of communications, collaboration and the customer engagement, stuff that we’ve talked about.

So, yes, it really is a much bigger opportunity, it’s bringing us into the sorts of deals that we really would not even have been able to play in with CIC. That’s just in its infancy. We are as I mentioned doing customer installs in Q3 for the directory portion of that which is the quickest and easiest thing to get going.

We expect to book deals in Q4, now given that this is a cloud subscription, of course the revenue doesn’t – there won’t be [indiscernible] revenue in Q4. But the orders will definitely start in Q4 and we are expecting to fill those orders ramp in 2015 and beyond. And I think it is reflected in the channel interest that we’re getting – that we’re getting interest on channel partners who are looking more broadly at communications beyond the contact center. And it’s just a very powerful message to go into large organizations with.

We just think there’s a tremendous gap in the market right now. You have some of the traditional companies that like Cisco that offer primarily premises spaced unified communications and then they may have telecommunications partners that host their stuff. They’re not a real cloud solution. They have a number of contact center offerings and then you also are seeing the rise of a number of low-end unified – published unified communications offerings.

But nobody really targeting large organizations with the scalability and features that they need for distributed multinational dialed plans of various localization and support around the world, capabilities that we have with Pure Cloud. So we’re just tremendously excited about the prospect of going into large organizations and say you too can move all of your communications, get rid of all the legacy PBX’s, contact center solutions, instant messaging platforms, all the stuff you had to piece together so far and get it all in a one very highly integrated suite of communications applications from the cloud.

Tavis McCourt – Raymond James & Associates, Inc.

Okay. Thanks a lot. And on the gross margin commentary on 2015, do you expect to proactively move customers or are the customers proactively request moving from the traditional CaaS offering through Pure Cloud or do you just expect most of the incremental growth to be on the Pure Cloud platform?

Don Brown

Yes, we’re mainly looking at the incremental growth. Although we do expect to – I mean we’re already having request from customers who are very interested in moving over from CaaS to Pure Cloud and we’re investing in migration tools technology that will facilitate that process. So we’ll be encouraging customers too although we plan to continue to support and sell CaaS for a long time because there are customers who want a single-tenant virtualized instance of a mature product like CIC.

So, most of the growth that we talked about moving forward really is in the form of new sales both in unified communications and contact center for Pure Cloud.

Tavis McCourt – Raymond James & Associates, Inc.

Okay. Thanks, Don.

Operator

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

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Great. Thank you. Guys, I guess a couple of questions; first, since – it’s been a few weeks since the prior call and you’ve had a little more time to do the due diligence internally to dissect things. Any other findings if you will in terms of a little more color on the drivers around the push out?

And then along those some lines, if you look at the deal counts, not just deals over seven figures but also those over 250k deal counts were down across the board in. And I guess coming into it, I had sensed it would be maybe a little more of a big deal focused push outs. But deal counts across the board were down.

So can you just talk about I guess those two things, the deal counts, where you saw the weakness and anything else you’ve learned since the last call?

Don Brown

Well I think it’s really more of what we’ve already been alluding to that we are doing bigger deals. We had some of those deals that slipped out, the burned us because it took a little bit longer than we expected.

I think I mentioned on the last call that we probably focused a little bit too much on the big deals that we had too much of the salesforce really concentrating on those big deals which is great when they come in. But we already had a program in motion from the beginning of the year to try to be focused more of the salesforce on the mid market and really expanding our reach, expanding the number of new deals.

So all the Q2 performance did was really further energize that effort. And so we have our salesforce very much attuned to that generation of new logos, new customers. We’re not happy at all to see a decrease in the number of new customers.

So we are hoping to execute better on both fronts signing the big deals and as I said, we’re off to a good start since a couple of those are already in and a couple more look like there will be in soon. And the salesforce has the message. We’ve kind of reoriented plans and provided other motivations to generate significant new logos for the second half of the year.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Okay. So outside of those and no other incremental learnings I guess as it relates to just dissecting any commonalities once the deals are pushed?

Don Brown

No, not really. Part of this is just the inevitable lumpiness that happens when you’re taking a snapshot quarter to quarter. Three months is not the long enough period to really be able to get a good view into the long-term trend of the business, but it did cost us to go back and really dive into our pipelines and our win rates and those sorts of things.

And we felt very good coming out of that analysis that our pipeline is at an all-time high continuing to grow. And as I mentioned with Pure Cloud even extending out into other collateral markets that we weren’t able to effectively address with CIC.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Okay. And I guess last one for me then, down the professional, should we think about those sequentially from here? Have we put in a floor? And then also as it relates to professional services, where are you in terms of utilization and how is that translating into weight time from contract signing to go live?

Don Brown

Steve, I’ll let you deal with the numerics there. Go ahead.

Steve Head

Yes. From a professional services, we see a flattening out the outfits [ph] definitely as we’re seeing more cloud business, the amount of professional services is not been as large. So we don’t see the growth in professional services like we’ve had the last few years.

From a margin standpoint, I think we said before we didn’t expect to continue to generate 20 plus margins on that. We had a lot of people and we are working hard. Now, we’ve got a better balance and we’re continuing to monitor it. I’d expect this to say in about the 20% margin because it includes professional services and education and managed services, some different things we do.

So we’re more in a range where we are currently compared to where we were last year.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Okay, and then I guess just the second part.

Steve Head

Remind me [indiscernible].

Jeff Van Rhee – Craig-Hallum Capital Group LLC

The utilization and how that’s translating into time to go live within professional services?

Steve Head

Yes, we’re doing a number of things. When we look at time to go live, on large premises-based customers, there’re a large of variables with the integrations and other things. We are seeing the time to go live accelerate some on the cloud side of the business as we’re learning how to do things more efficiently. Some of it is with professional services, some assist with the way we’re deploying the cloud solution. So we’re seeing that accelerated.

The actual utilization of the staff is probably not quite the size it was just because we were, you know, going back from our previous comment working the folks order than we wanted to and we just needed to get the better balance of staff.

Jeff Van Rhee – Craig-Hallum Capital Group LLC

Okay, I’ll leave it there. Thank you.

Operator

(Operator instructions) We do have a question from Mike Latimore with Northland Capital. Your line is now open.

Mike Latimore – Northland Capital

Hi, there, thanks. As the revenue that’s in deferred, that you expect to see in the future, do you expect that in the third quarter or in the second half of the year?

Steve Head

Well, if it’s related to those two deals, Mike that we talked about before that we weren’t able to recognize, some of that – on one deal it’s going to depend on how we end up accounting forward and whether we get customer acceptance.

I think we talked about it before where they have a couple of different pieces of software. They’re in operation and they’re working using the software, but they haven’t signed off an acceptance. So we’re looking at a couple of ways of how we would recognize that revenue.

In one case, we get most of it this year and then in other case, it might be spread some. And the other one where we had the large professional services engagement that cost us to recalibrate, we’ll be picking up a good portion of that this year we expect, but probably not all of it.

So I guess the end result of all of that, between the two of them, we’ll have a good portion of it, but we won’t necessarily have all of it that we were expecting to have.

Mike Latimore – Northland Capital

Okay. I thought there was also a large cloud customer that was a current customer where they ordered a little bit more than you were expecting. I guess is that one customer going to – do you expect them to order the full amount by year end?

Steve Head

That’s my – well I don’t know about by year end. I think from what I’ve heard, there will be an additional order expected. I just don’t know the timing unless Don has some additional insight on that one.

Don Brown

No, I don’t.

Mike Latimore – Northland Capital

Okay. And then over the 50 million of Pure Cloud pipeline, are most of those customers are large customers that you’re seeing on the pipeline?

Steve Head

Yes.

Mike Latimore – Northland Capital

Okay. And at what percent of them, say, are evaluative CaaS versus Pure Cloud or do they gravitate to Pure Cloud an easy way [ph]?

Don Brown

Actually, you know what, that’s a good question. I would say that most of them would immediately to Pure Cloud that either they were looking for other – some of them are unified communications customers, some are directory customers. We’ve got some multimillion dollar directory deals in the pipeline.

So most of what I’m referring to there really is stuff that came directly to Pure Cloud and in most cases really would have been a fit for CIC or CaaS.

Mike Latimore – Northland Capital

And just on the – you might have touched on this already, but on the recurring service gross margin, that was down a little bit sequentially, does that trend continue or does is it stabilized there?

Steve Head

Well we’re doing a number of things, Mike with the CaaS operation to run it more efficiently. We have made some staffing changes as I think you know about that we announced earlier in the year with reorganizing some of the operation. And we’re still working to see what kind of efforts we can make there.

It’s not going to be something that turns around in the short run. It’s probably going to be a few quarters before we’ll see a meaningful difference and that will allow us recurring margins to start moving back up.

They continue to be very strong on the maintenance side, but it’s the CaaS operation that we need to make more profitable than where it is today. And that’s just going to take some time.

And at the same time, we could improve the profitability, but since it’s growing relatively faster, it offsets that profitability growth in the short run.

Mike Latimore – Northland Capital

And I guess my last question, if you do have some CaaS customers that migrate to Pure Cloud, do they have to pay anything incremental for that or do they get that automatically just like basically other contracts?

Don Brown

I think that for the most part, we’ll just move them over and move them from a CaaS contract to a Pure Cloud contract with nothing other than the term of the contracts may change, but we’re really not looking at that as a revenue source.

Mike Latimore – Northland Capital

Yes, thanks.

Operator

And our final question comes from the line of Craig Nankervis with First Analysis. Your line is now open.

Craig Nankervis– First Analysis Securities Corp.

Thank you very much. Don, are large organizations asking for the solution you discussed with Pure Cloud that also encompasses unified communications? I mean, I guess by the sound of it, Pure Cloud pipeline is starting to happen, but I’m interested to know how much you hear request from that wider vision for Pure Cloud at the large enterprise you’re hearing?

Don Brown

Yes. I think that there’s still some surprise on the past of large organizations to realize that they can. So we’re at the beginning of that trend. But I think if you step back and look at the broader picture of IT and cloud in general, it’s inevitable. So I guess we’re seeing a combination of some companies who are coming to us because they hear about Pure Cloud and are intrigued by the notion of getting rid of hodgepodge of internal communications devices and systems and moving to the cloud.

But also it’s through proactive efforts where we go out, I go out and meet with CIOs and CEOs at large companies and tell them that that is a possibility. That it’s not just reserves for the sorts of small companies that are moving their communications to the cloud very quickly as you can see from the results of some of the cloud vendors who are focused on the lower end of the market. But I think it’s the same thing we experience with the contact center over the last five year that became a snowball that nobody disputes anymore. And I’m convinced we’re going to see exactly the same thing take place with corporate communications.

Craig Nankervis– First Analysis Securities Corp.

Thank you. I think you partly addressed this in an earlier answer to a question, but I’d like to ask it in a different way and excuse me if there’s an overlap.

You talked, especially on the last call, pre-announcement call about how much you’re going to retreat somewhat from large deal pursuits to focus on more mid-market stuff. So is that –

Don Brown

No, we didn’t say that. And I wouldn’t say that. We’re not retreating from large deals in any way. We’re just trying to do it in a way that it doesn’t have all the sales people out there trying to find the next big whale, but sort of we do a more effective job of segmenting the salesforce and the marketplace. But we’re still going after big deals as much as ever.

Craig Nankervis– First Analysis Securities Corp.

As much as ever. So you wouldn’t expect to see your big deal activity diminish in any way going forward? It’s just you’re somehow going to still accomplish that, but also allocate things so that you get more mid market. However it is you’re going to do that, that you’re going to be in – that’s what’s going to happen?

Don Brown

Yes. We certainly don’t want to have more mid market deals at the expense of large deals. But what we can do is really incent the salesforce and through the way we manage them, the way we commission them to make it clear that just going out and hitting one colossal deal is not the only objective we’re setting out for you.

We want you to hit that big colossal deal or multiple of those, but in order to really gain recognition and the maximum in commission credit. You also need to go out and being in the bushes for those mid market deals because that’s the way we believe that we expand our brand and increase the overall awareness of us as a company.

So we don’t think we have to give up the large deals at all in order to build that mid market presence.

Craig Nankervis– First Analysis Securities Corp.

I see. You’re comfortable that both can be accomplished?

Don Brown

Yes. And I think you’ll see with Pure Cloud that we are going to do is really have more of a marketing driven sales approach so that in rather than having to rely – pardon me – on the field salesforce to do all of that, that marketing can start to contribute. Because with Pure Cloud, we’re going to have a product that we can use marketing dollars to drive customers or prospects to a website and let them sign up directly and try the service, deploy the service in a manner that we haven’t been able to do before.

And so we think that also is really going to enhance our positioning and effectiveness in the mid market.

Craig Nankervis– First Analysis Securities Corp.

Okay. And then I just wanted to confirm, did you say you’re going to run the overall business at 70% plus gross margin next year? Is that – do I have that right?

Steve Head

No, no.

Don Brown

No, no, I don’t think we have said [ph]. That would be great. You’re going to give Steve a heart attack, all right.

Steve Head

Yes.

Don Brown

We’re not going to make this transition in 12 months. But what we said was, no, what I said was that we are going to – we designed Pure Cloud so that we can get it once we ramp it up that we can get it as a 70% plus gross margin business.

Craig Nankervis– First Analysis Securities Corp.

Right.

Don Brown

So next year will still be a mix of CaaS and Pure Cloud as well as CIC. And even Pure Cloud, we’re going to have ramping period during which we are still making investment in front of orders before we get to that 70% mark. But we’ve just done a lot of analysis looking at once that business ramps, what’s the incremental gross margin we can recognize on a new deal. And we think that’s going to be in excess of 70 points.

Craig Nankervis– First Analysis Securities Corp.

Thanks.

Don Brown

You bet.

Operator

At this time, I’m showing no further questions. Then I would like to turn the call back over to management for closing remarks.

Don Brown

Okay. Well thanks, everybody. Hopefully we’ve sufficiently answered your questions about our stumble in Q2. But we’re excited about the second half of the year and beyond and look forward to the next call. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference, this does conclude the program and you may all disconnect.

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