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Zix Corp. (NASDAQ:ZIXI)

Q1 2011 Earnings Call

April 26, 2011 5:00 pm ET

Executives

Geoff Bibby - VP, Corporate Marketing

Rick Spurr - CEO

Mike English - Controller

Analysts

Mike Malouf - Craig-Hallum

Jeb Terry - Aberdeen

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2011 Zix Corporation Earnings Conference Call. My name is Jeff, and I will be your operator for today. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

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

Geoff Bibby

Good afternoon, I am Geoff Bibby, Vice President of Corporate Marketing for Zix Corporation. Thank you for joining our Q1 conference call.

You can find our earnings press release on our investor website at investor.zixcorp.com. The earnings release contains instructions for accessing a recording of this call.

Our Chairman and Chief Executive Officer, Rick Spurr, will provide an overview of the company's performance in the quarter; then our Controller, Mike English, will give you our details of our financial results. During their discussions they will make year-over-year comparisons with our revenue, gross profit, operating expense and operating margin, those comparisons to our continuing Email Encryption business, excluding our discontinuity e-prescribing business.

Later in the call they will answer questions from analysts and institutional investors. Listeners can also submit questions during the call to our investor relations' mailbox at invest@zixcorp.com.

Rick and Mike will provide forward-looking statements on matters such as forecasts of revenues, earnings, operating margins, and cash flow, projections about new contracts or business, and comments on trend information, such as privacy legislation.

The company undertakes no obligation to publicly update or revise any forward-looking statements. Forward-looking statements are subject to risks that could cause actual results to differ materially from our expectations. The risk factors section of the company's most recent 10-K filing with the SEC gives some examples of those risks.

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

Now, I'm pleased to turn the call over to Rick.

Rick Spurr

Good afternoon everyone, and thank you for joining Zix Corporation's 2011 first quarter conference call. I am pleased to report another solid quarter for the company as we continue to build upon the momentum of a very strong 2010. As we have stated over the past few quarters, we continue to build a solid and predictable business based on our successful subscription model.

As a result, we reported $9.3 million in revenue in the first quarter, up from 24% year-over-year, and slightly above our guidance of $9 million to $9.2 million.

This quarter represented the strongest Email Encryption quarter in the company's history, outpacing last quarter's $8.8 million in revenue. New first year orders for the quarter were $1.5 million, down from $2.2 million in the first quarter of 2010 and below our internal expectations.

We believe our new first year orders were impacted by several factors, none of which appear to be long-lasting or recurring. I'll elaborate on some of these factors later in the call.

Total bookings for the first quarter came in slightly below last year's Q1 number at $9 million, down 3% primarily due to the decline in new first year orders. Our bookings backlog at the end of March was $49.7 million, up 12% over Q1 of 2010.

As most of you know, last year was our first full whole year of GAAP profitability, and we are pleased to report that we continued that trend this quarter, recording our fifth consecutive quarter of GAAP profitability. Our GAAP net income for the quarter was $2.4 million or $0.03 per share, an increase of 237% over the first quarter of last year. Our non-GAAP adjusted net income for the quarter was $2.5 million, an increase of 104% year-over-year and resulted in $0.04 per share on a fully diluted basis.

During the quarter, we generated approximately $3.5 million in cash flow from operations, an increase of $900,000 year-over-year. We ended the quarter with a cash balance, including investments in commercial paper of $24.1 million, which was down to $570,000 from our year-end 2010 as a result of our share repurchase plan.

In the first quarter, we bought back $5 million worth of our own stock as part of the share repurchase program we initiated in March of this year.

Mike English will provide more details on the buyback in his remarks. But to summarize, we feel our healthy balance sheet and strong cash flow provide us an opportunity to invest in growing our business while also driving value to our shareholders through a share repurchase.

The last metric I want to cover in my overview is our ZixDirectory membership. We continue to add to our industry-unique cloud-based ZixDirectory, which currently has 26 million members, including some of the most respected institutions in the country. This year, Directory architecture the only one of its kind, allows for unequalled ease of use, most notably through our transparent email encryption capability, and is growing at approximately 100,000 new members per week.

Now, let's discuss what happened during the first quarter with our new first year orders. But first of all to review, we have three sources of new first year orders. The first is our direct enterprise group, which is aptly named sales Direct to large commercial enterprises.

The second is our corporate group, based in Burlington, Massachusetts which is primarily an inside sales team who sells into the small and medium business market and to the Federal Government and often working closely with our value-added resellers and managed security service partners.

The third source is our large OEM partners; Google, Symantec, Webroot and others. During the quarter, a majority of our new sales were derived from our VAR, OEM and third-party distribution channels, continuing the favorable trend we saw during 2010. VAR, OEM and third-party distribution channels represented 57% of our new first year orders in the first quarter, compared to 53% throughout the course of 2010.

Our OEM partners, a subset of this third-party distribution, including Google, Symantec and Webroot, continued to grow and accounted for 34% of new first year orders, up from 21% for full year 2010. We now have 120 managed security service providers and VARs across the country, up from 106 last year.

As we have said before, reaching critical mass in the various industries we serve is an important goal for us to accelerate growth, and our reputation for leadership and excellence in offering the best-to-breed solution is helping us gain momentum with these third-party relationships, who in turn expand our coverage and help us increase our penetration into markets in the U.S.

We have been successful in building these third-party relationships, positioning ourselves to meet heightened demand in the marketplace for our product offers. VARs, OEMs and third-party resellers are augmenting our direct sales force in fulfilling this increased demand.

Where we experienced a decline in the first year orders during the first quarter was to some extent in our enterprise group, but markedly in our corporate group and sales to small and medium business and the federal government. As I mentioned earlier, we attribute this Q1 decline to some one-time factors that we believe may have caused a push-out of some large enterprise deals and caused inefficiencies in our corporate sales group.

The most obvious factor affecting the enterprise team was the earthquake and Tsunami in Japan, which occurred in early March. We are engaged in two substitute Email Encryption evaluations being done by U.S, subsidiaries of two large Japanese companies. Both of these opportunities were put on hold abruptly and unexpectedly, coincident with the disaster.

The corporate sales group was impacted by federal procurement slowdowns due to the absence of a congressionally approved budget for fiscal 2011 and by a variety of other causes, including the extreme weather and snow in the Northeast and the sales team reorganization implemented in Q1.

We believe that none of these factors will be long-lasting or recurring issues for our business and would expect new first year orders to rebound in the second quarter, as we continue to experience high levels of interest and activity in the market.

In fact, the month of April has established a new record in terms of interest and lead generation for the company. We, like many other companies provide webinar sessions for our customers and prospects to discuss market trends and to explain how ZixCorp solutions can solve their compliance and email security issues. We view attendance of these events as a leading indicator of interest.

In month of April, we witnessed more registration and attendance at our marketing events than at any time in the company's history. This trend gives me confidence that the weakness we saw in the new first year orders in the first quarter was not a reflection on our market or our solution, but rather several one-time factors.

We remain excited about the demand we are seeing in the marketplace, as the essential lead for data security and integrity grows quickly and is widespread. Reports of data breaches and identity theft exposures have now become commonplace. And as you would expect, there is an unprecedented emphasis on risk management and compliance as it relates to data security.

For example, as in the healthcare vertical, there is a heightened focus on more aggressive enforcement of HIPAA 2 by the federal government, more than we have ever seen. Just this past quarter, Signet was fined $4.3 million for not adhering to the security mandates of HIPAA 2. Also during the past quarter, Mass General Hospital was fined $1.5 million for a similar infraction.

Just this month, the Department of Health and Human Services started offering training to States Attorney's General offices on how to enforce HIPAA 2 upon healthcare organizations and other covered entities in their state, empowering states to enforce the security legislation and retain the proceeds from any fines. Obviously this type of enforcement action is driving those healthcare institutions that are not in compliance to step up their timetable to acquire the technology needed to adhere to these regulations.

Another example of the heightened demand for action is the proposed Privacy Legislation sponsored by Senators Kerry and McCain that is currently under review in the United States Senate that would require companies to provide data protection for their customers.

We had talked in the past about state legislation and Massachusetts, Nevada and Washington being growth drivers for our email encryption solution. However, if broader federal privacy laws are passed, we will expect significant increased demand for email encryption, as thousands of companies beyond their core regulated verticals of healthcare, finance and government would suddenly become regulated with respect to data privacy.

With or without new legislation, we are uniquely positioned to capitalize on increased demand due to our cloud-based transparent email encryption solution with currently $26 million members and our mature (set of) distribution partners, including our large OEM partners, must notably Google.

We are already, according to the Gartner Group, "The leading email encryption service provider by a wide margin." However, we'll continue to invest to expand our lead. In addition to our cloud-based transparent solution, which is highly differentiated from our competition, last quarter we announced our new ZixMobility solution, which remains on track for delivery in July. We are very excited about this new product and see this launch as raising the bar even higher for email encryption in the mobility marketplace.

We are living in the age of a mobile society with both our personal lives as well as our work lives. New smartphones have changed the way we do business, and mobile email encryption is essential just as it is on your desktop. The trick is, it has to be seamless and easy to use, which is simply not available today. Our ZixMobility solution brings customers a seamless email encryption solution that is designed specifically for a user's particular device.

Our technology gives us the ability to identify what device the user has, be it an iPhone, BlackBerry or Android smart phone, and optimize the way of design and ease of use without neglecting the need for email encryption. This one-click access design doesn't require any type of mobile application download is truly unique to the industry. It will be very difficult for our competitors to replicate.

Our strategy for the rollout of ZixMobility is to offer it free to our paying customers, using it as a differentiation strategy and raising the bar on our leadership in the email encryption space. We also believe it will strengthen our pricing power in new deals and at renewal time. We are very excited to begin delivery of this revolutionary offering into the marketplace in July.

Our most recent example of innovation to expand our lead and generate new sales is the new product we announced today, (ZixAccess). If we are successful, and market acceptance meets our expectations then we'll not only see growth in sales in the short-term but longer term upsell opportunity as a result of the seeding strategy which is the focus of (ZixAccess).

Today, we have 3,000 ZixGateway customers and another 3,000 ZixMail customers that are sending Zix-encrypted messages to tens of thousands of recipients who today are not Zix customers but who are Zix prospects. When one of these recipients retrieves a Zix encrypted message, they have to go to a portal and answer a password.

(ZixAccess) is a new product which if purchased by a non-Zix customer will allow their employees to receive all their Zix-encrypted messages transparently, without the need to go to a portal and without the need to enter a password at all. This will eliminate workload disruption for their employees and improve productivity.

We have a detailed list of non-Zix customers, some very large, telling us exactly how many Zix messages their employees must decrypt via a portal each month. In many cases, it's thousands of messages. Using this list, we will take (ZixAccess) to the market and hopefully create a relationship and a revenue stream with these new customers, who in many cases have a competitive solution in place.

Our pricing for this product is designed to be very affordable, less than $10,000 per customer per year. So we hope for strong market acceptance.

Another feature that we will include is the ability for these non-Zix customers to in effect audit their outgoing mail streams, to make sure there are no compliance violations due to leakage of PHI, Personal Health Information, Personal Financial Information, or other sensitive data. Obviously, if our filters can detect leakage, it will be clear to these customers that they upgrade to use Zix for outbound encryption using our full gateway solution that uses these same filters, they will be complaint with the relevant legislation and better manage their brand and reputation in the marketplace.

We see this new product as not only a revenue stream, but also a great lead generator for our full gateway product.

Before I turn call over to Mike English, our Controller, to discuss the financial results in detail, let me give you a summary of some of our Q1 successes. First of all in the fourth quarter of 2010, we announced a win at Highmark, the large, reputable Blue Cross Blue Shield Company in Pennsylvania and we are happy to report that the implementation of our solution has gone as planned and all Highmark's users are up and running. An important aspect of that win is the fact that we displaced a competitive solution from Tumbleweed, now owned by Axway.

In Q1 of 2011 we won another Blue Cross Blue Shield account from Tumbleweed, Blue Cross Blue Shield of Mississippi. We are very confident in the superiority of our technology and our solution and are hopeful that this replacement momentum can continue not only in healthcare, but across all verticals.

Tumbleweed at one time in the 2002 to 2006 timeframe was by far our largest competitor. And we estimate that their technology, although no longer current, is being used by approximately one million users to send encrypted email. So we see this as a significant opportunity to replace aging, competitive technology.

For context, using an apples-to-apples comparison, our encryption technology is being used by approximately 1.6 million users to send encrypted email. Also in Q1, in the financial services sector, which for us includes insurance, we added AIG through our partner Webroot with an initial deployment of over 5000 seats. Our large insurance customers now include The Hartford, Northwestern Mutual, TransAmerica, AIG and others.

In the government vertical in Q1, although the end quarter new first year order contribution was quite small, we saw the beginnings of a large implementation for 5,000 users of our email encryption in the State of Wyoming, also through Google. This will continue to contribute to our new first year orders for the next few quarters.

In closing, I am pleased with our record results during the first quarter. I am not pleased with the shortfall in new first year orders in Q1, but remain very positive and see the causal events as being one-time in nature.

Now, I'd like to turn the call over to Mike English, our Controller, to discuss our first quarter financial results in more detail. And then, we will be happy to take questions.

Mike English

Thanks Rick, and good afternoon everyone. As Rick mentioned, we are pleased to report strong results for the first quarter in our key financial metrics; revenue, GAAP and adjusted net income and EBITDA.

GAAP net income was $2.4 million for the quarter as compared to $712,000 for the same period in 2010.

Let me detail the first quarter financial results, beginning with revenue. We achieved revenues from continuing operations of $9.3 million for the first quarter, which compares to $7.5 million for the first quarter of 2010. This is slightly above our previous upper end guidance of $9.2 million.

Our OEM partners drove approximately $990,000 of the revenue increase, a 79% improvement from the first quarter a year ago. Our direct sales to enterprise and corporate customers, including through our resellers and managed security service providers, drove the remaining growth.

We ended the first quarter with bookings backlog of $49.7 million, which is a 12% increase over the $44.4 million backlog at the end of the first quarter of 2010. As a reminder to everyone, our backlog is comprised of contractual commitments that we expect to amortize into revenue in the future as the services are performed. The revenue recognition of the backlog is affected by both the length of time required to deploy a service and the length of the service contract.

We anticipate approximately 55% of the backlog being recognized into revenue within the next 12 months.

Let's move on to look at our various margins as well as the details in our expenses. We achieved first quarter adjusted gross profit from continuing operations of $7.5 million, 81% of revenues. This compares to $6 million, 80% of revenues for the same quarter last year. On a sequential basis, it compares to $7.2 million or 81% of revenues for the fourth quarter of 2010.

With regard to adjusted operating expenses from continuing operations, adjusted R&D and SG&A expenses totaled $4.9 million in the first quarter of 2011 compared to $5.1 million for the same period last year.

Adjusted R&D expenses were $1.3 million for the first quarter of 2011 compared to $1.3 million in the first quarter of 2010.

SG&A expenses for the first quarter were $3.6 million, a decrease of $228,000 over the same period last year. Adjusted operating margin from continuing operations for the first quarter was $2.5 million, 27% of revenues. This compares to margin of $887,000 or 12% of revenues for the same quarter last year.

Our adjusted EBITDA for the first quarter was $2.9 million, 31% of revenues, compared to $1.6 million, 22% of revenues for the first quarter of 2010. Capital expenditures for the first quarter were $285,000, and depreciation expense for the quarter was approximately $331,000. Depreciation is recorded in the various P&L line items with approximately 75% recorded in cost of revenues.

Ending cash, including commercial paper investments was $24.1 million, a decrease of approximately $470,000 from Q4, 2010. Compared to this time last year, cash, including commercial paper investments increased $8.3 million. The decrease in the first quarter was driven primarily by the repurchase of $5 million of our common stock, which more than offset the cash provided by operating activities and by stock option and warrant exercises.

During the first quarter, under our previously announced share repurchase program, we repurchased $1,368,300 shares at a weighted average price of $3.65 per share. To remind everyone, our Board has approved the repurchase of up to $15 million of our common stock, including the $5 million purchased in the first quarter. This program terminates on September 30 of this year.

Adjusted net income for the first quarter was $2.5 million, which compares to $1.2 million for the same period in 2010. Our adjusted net income for fully diluted share of common stock for the quarter was $0.04, and $0.02 for the same period in 2010.

Now let's move to guidance for 2011. For the second quarter of 2011, we project our fully diluted adjusted earnings per share to be $0.03 per share on projected revenue guidance, which is $9 million to $9.2 million.

For full year guidance, we reaffirm previously issued 2011 revenue guidance of $38 to $40 million, and fully diluted adjusted earnings per share of $0.14 to $0.16. This guidance will yield adjusted EBITDA margin of approximately 30% and adjusted operating margin in the high 20s.

In closing, I would like to say again that we are pleased with the first quarter operating results and we look forward to continued strong performance in 2011.

With that I'll turn it back to Rick.

Rick Spurr

I'll turn the call back to the operator and see if we have any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question of the day comes from the line of Mike Malouf with Craig-Hallum.

Mike Malouf - Craig-Hallum

I have a little bit of a question on new first year orders. I know that you talked about it being one-time in nature of slowdown. And I can understand obviously the federal slowdown with regards to the budget. Japan obviously is a one-time event. The sales team reorganization, I'm wondering if you could give a little bit of color on that especially in light of last quarter where we actually talked about the direct sales being down. And you had commented that that was in part because of their success in helping drive the OEM.

So I was a little surprised to see that you are doing a sales force reorganization after that.

Rick Spurr

The reorganization was related to channels. But I want to reemphasize first that the direct sales contribution being down at the tail end of last year, was as I said, you could say by design, we compensate the direct sales force in that corporate team for business that they sell directly or through their related value-added resellers. And you do that to encourage the sales people to nurture and grow and develop the channels, so that over time the channels are bringing more business to you independently.

So that wasn't a surprise to us. In fact, as I said, it was in effect, by design, to nurture the channels. The reorganization that we did in the first quarter was to add some additional resource to deal with the channels, the value added resellers and managed security service providers of which we now have 120 and to align them in a one-to-one relationship with the senior sales people that oversee the sales in the various territories.

So it was an investment and realignment for ultimately, better productivity. But as we all know, when you go through those sorts of changes, it is disruptive as people figure out what their new territories look like and they figure out how to work with their new partners, and we bring new people in, and all of what takes place when you go through a re-org.

I didn't anticipate of course, it would be as disruptive as it apparently was.

Mike Malouf - Craig-Hallum

And then with regards to total orders, those were down to $9 million. And the first time, I've seen your backlog actually down sequentially. And obviously, given that you are guiding for revenues to be down sequentially first time of that as well for the Email Encryption.

So I guess I'm just trying to get a sense, has there been some anticipated cancellations or maybe a spike in that number?

Rick Spurr

I'm sorry Mike, when you say, spike in that number what number are you referring to?

Mike Malouf - Craig-Hallum

Maybe a spike-down in the renewal rate?

Rick Spurr

Okay. No, there's not been an increase in cancellations or a spike-down in the renewal rate. I have for over a year now suggested that people should model or think about renewal in the 90% range, and that hasn't changed. The backlog went down a de minimis amount, it came to $200,000.

And we said before that you could see the backlog decrease based upon the timing of renewals. So there are two major variables here; one is, new first year orders, which we know are down, and the other is, what's the value of contracts coming up in a given quarter for renewal.

A little color; one of our very largest accounts actually renewed a couple of days into the month of April. Had that renewed in late March, you would have seen a marked increase in our backlog. So it really has to do with timing.

And as we said, the shortfall in new first year orders, those two things in combination caused it to go down slightly, but it's certainly not anything we are alarmed about other than the new first year orders thing. I think I made that clear that I am not happy with that.

Operator

(Operator Instructions) Up next, we have Jeb Terry with Aberdeen.

Jeb Terry - Aberdeen

I'm really intrigued by your (ZixAccess). So if I understood it correctly, you have approximately 9,000 current focused customers.

Rick Spurr

No Jeb, 6,000; so we have 3,000 ZixGateway customers. They have our full function product. And then another 3,000 ZixMail customers.

Now, some of ZixMail customers are multiple people using ZixMail in a company. So we actually have 50,000 copies of ZixMail, but those 50,000 copies are contracted by 3,000 companies. So the total there is 6,000 companies.

Jeb Terry - Aberdeen

How many companies would represent the kind of addressable opportunities? Those 6,000 companies or 50,000 users are interacting with some thousands of companies that would represent your target market. Can you kind of frame how many thousands of companies would be the target customers for (ZixAccess)?

Rick Spurr

I think I just said tens of thousands. As you know, we have 26 million entries in the ZixDirectory. Only 1.6 million of those are represented by those 6,000 customers I just talked about. And that would then suggest that 26 minus 1.6, 24.4 million of those people are recipients living in non-Zix customer accounts.

And when you detail how many customers that is, it's tens of thousands, but I haven't chosen to be more granular than that. And clearly, it's the ones that are getting lots and lots of ZixMail everyday. Frankly, some of the big ones are getting over 10,000 messages a month. And then that trails off into 9000, 8000, 7000.

There are lots and lots of companies that already see Zix, and we're going to, number one, try to generate some revenue from that. But I think more importantly, introduce our brand to those companies and begin to show them how an upgrade to our whole solution would be even more advantageous and have greater value to them.

Jeb Terry - Aberdeen

Well, that sounds like a big opportunity. Another question, I actually sat in on one of your webinars, and the webinar interface is something like 500 attendees. It seems like a lot. And you said that you have a lot of attendance. And I was just trying to calibrate that relative to say prior years attendance and if there is any judge.

Rick Spurr

In the webinar we ran in April, we had over 500 attendees actually come. We had 850 registrants, but you always have to fill it up. We had 540 actually participate, and the majority of those were still there an hour and a half later listening to our demo and presentation. That attendance is well over double the volume we've had in any such events through the last year and a half, and 25% higher and the next highest attended event in the history of the company.

So yes, that's what I was referencing when I said the indication of activity and interest is quite high, and it is those kinds of events that give our sales team leads, which then lead to pipeline and apply some close ratio, and over time you get business out of that. It's hard to draw any more specific relation between those sorts of numbers and sales, but that is definitely a positive indicator.

Jeb Terry - Aberdeen

And just one last thing on the government vertical. There are sort of these cross-sections of users in Wyoming. Is there any color or any indications you might be able to give us about other government initiatives? I know you talked about machine-driven encryption in the past. Anything on that front?

Rick Spurr

I think all I'll say is that I am encouraged and expect a good year from the government sector and probably I'll leave it at that. I'm saying that largely based on what I know in the federal government space, more Southern state. But we've had a steady inflow of state business. And as we said earlier, getting these channels engaged and trained we hope will lead to more of that.

Operator

Ladies and gentlemen, this concludes the Q&A portion of the call. I would now like to turn the presentation back over to Mr. Rick Spurr for closing remarks.

Rick Spurr

I just want to thank everybody for their continued interest and support. And we look forward to getting ZixMobility and (ZixAccess) in the marketplace and look forward to an exciting quarter.

Operator

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

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