Open Text Corporation (NASDAQ:OTEX)
Q3 2016 Results Earnings Conference Call
April 27, 2016, 05:00 PM ET
Greg Secord - Vice President-Investor Relations
Stephen Murphy - President
Mark Barrenechea - Chief Executive Officer and Chief Technology Officer
John Doolittle - Executive Vice President and Chief Financial Officer
Richard Tse - Cormark Securities
Steven Li - Raymond James
Paul Steep - Scotia Capital
Blair Abernethy - Industrial Alliance Securities
Paul Treiber - RBC Capital Markets
Eyal Ofir - Dundee Capital Markets
Thank you for standing by. This is the conference operator. Welcome to the Open Text Corporation Third Quarter 2016 Financial Results Conference Call. As a reminder, all participants are in a listen-only mode and the conference is being recorded. After the presentation, there will be an opportunity to ask questions. [Operator Instructions]
I would now like to turn the conference over to Mr. Greg Secord, Vice President, Investor Relations. Please go ahead.
Thank you, and good afternoon, everyone. I’d like to welcome you to today’s call. With me is Open Text’s President Steve Murphy, Open Text’s CEO and CTO, Mark J. Barrenechea; and our Chief Financial Officer, John Doolittle. As with our previous calls, we’ll read prepared remarks followed by a question-and-answer session. The call will last approximately one hour with a replay available shortly thereafter.
I’d like to take a moment and direct investors to the Investor Relations section of our website where we posted several PowerPoints that maybe referred to during this call, including our quarterly supplemental update on the financial results; as well as our recently announced acquisitions. I encourage all investors to download the presentation.
As with previous quarters, we’ve updated a summary table highlighting Open Text’s historical trends and financial metrics. These trended financial spreadsheet is downloadable from the front page of the IR section of our website as well. Open Text will be hosting an Investor Day in New York on Thursday May 12. If you’re interested in attending or want to find out more information, please contact myself or the Investor Relations team directly. And with that, I’ll proceed to the reading of our Safe Harbor statement.
Please note that during the course of this conference call, we may make statements relating to future performance of Open Text that contain forward-looking information. While these forward-looking statements represent our current judgment, actual results could differ materially from a conclusion forecast or projection in the forward-looking statements made today. Certain material factors and assumptions were applied in drawing any such conclusion while making a forecast or projection as reflected in the forward-looking information.
Additional information about the material factors that could cause actual results to differ materially from a conclusion, forecast or projection in the forward-looking information and material factors or assumptions that were applied in drawing a conclusion while making a forecast or projection, as reflected in the forward information, as well as risk factors that may project the future performance results of Open Text are contained in Open Text's Forms 10-K and 10-Q, as well as in our press release that was distributed earlier this afternoon, each of which may be found on our website. We undertake no obligation to update these forward-looking statements unless required to do so by law.
In addition, our conference call will include a discussion of certain non-GAAP financial measures. Reconciliations of non-GAAP financial measures to their most directly comparable GAAP measures have been included in today's press release, which of course may be found on the website.
And with that, I'll turn the call over to John.
Very good, thank you very much, Greg. Welcome, everybody, to the call. Let's go through the numbers and my references will all be in millions of US dollars unless I indicate otherwise.
Total revenue for the quarter was 441, down 2% compared to 448 for the same period last year and up 2% on a constant currency basis. This decrease is related to professional services performance in the quarter and Steve will comment. For fiscal 2016 year-to-date total revenue was $1.34 billion, down 2% compared to $1.369 billion for the same period last year and up 4% on a constant currency basis.
Recurring revenue for the quarter was 376, down 2% year-over-year compared to 384 for the same period last year and up 1% on a constant currency basis. For fiscal 2016 year-to-date recurring revenue was $1.143 billion down 2% compared to $1.172 billion for the same period last year and up 3% on constant currency basis.
Next the impact of foreign exchange. In Q3, our revenues were negatively impacted by 15 and the adjusted EPS was negatively impacted by $0.01 compared to the same period last year. The negative effect at 15 by revenue type is broken down as follows. License, 3; cloud services, 4; customers support, 6; and professional services and other, 2.
For fiscal 2016 year-to-date our revenues were negatively impacted by 80 and adjusted EPS negatively impacted by $0.14. The negative effect of 80 by revenue type is broken down as follows: License, 16; cloud services, 19; customer support, 33; and professional services and other, 12.
License revenue for the quarter remained stable at 64 compared to the same period last year and up 6% in constant currency. For fiscal 2016 year-to-date license revenue was stable at approximately 198 and up 8% on a constant currency basis. Cloud services revenue for the quarter remained stable at 148 compared to the same period last year and up 3% in constant currency. Year-to-date cloud services revenue is 444, down 3% compared to 456 during the same period last year and up 2% in constant currency.
New MCV bookings this quarter were 46 compared to 38 in the same period last year up 21%. Year-to-date new MCV bookings were 144, stable compared to last year and up 4% in constant currency. Customer support revenue for the quarter was stable at 184 compared to the same period last year and up 3% in constant currency. Year-to-date customer support revenue was 553 up 1% compared to 548 during the same period last year and up 7% in constant currency.
Professional services and other revenue for the quarter was 45, down 14% compared to 52 in the same period last year and down 10% in constant currency. Year-to-date professional services and other revenue was 145 down 14% compared to 168 during the same period last year and down 7% in constant currency. Gross margins for the quarter were basically flat with the exception of professional services.
License margins increased to 96 from approximately 95 primarily due to lower third-party technology costs. Cloud services and subscriptions margin was 58 compared to 59% from the same period last year. Customer support margin increased to 88% compared to 87 in the same period last year primarily due to reduction in direct labor costs and professional services margin was 16 compared to 19% in the same period last year due to the decline in revenue.
For similar reasons gross margins for year – gross margins year-to-date are as follows. License margin was 96 compared to 95 in the same period last year; cloud services, 60 compared to 61 in the same period last year, customer support, 88 compared to 87 in the same period last year; and professional services, 21 compared to 23 in the same period last year. Adjusted operating income was 138 this quarter up 20% compared to 115 in Q3 of last year.
On a constant currency basis adjusted operating income was 139, up 21%. Year-to-date adjusted operating income is 459 up 8% compared to 424 during the same period last year and on a constant currency basis it was 479, up 13%. Adjusted operating income was up both a quarter and year-to-date basis as a result of a decrease in expenses of approximately 30 and 63 respectively, resulting from restructuring efforts announced in May, integration of actuate and ongoing expense management.
Adjusted net income increased by 21% to 98 this quarter, up from 81 in Q3 of last fiscal year. This is primarily due to a 23 increase in adjusted operating income that was partially offset by higher taxes due to a change in the company's adjusted tax rate from 18% to 20%. Year-to-date adjusted net income was 323, up 2% from 318 during the same period last year and up 22% or 7% on a constant currency.
The increase on year-to-date basis primarily due an increase in adjusted operating income of 35, partially offset by higher interest from the high yield notes that were issued Q3 of last year and higher tax rate as I mentioned previously.
Interest expense was 16 in the third quarter after recognizing approximately two income earned from a cost basis investments. Net interest expense quarter is comparable to 16 last year.
On a year-to-date basis, interest expense is up 18 due to interest on high yield notes and offset by the income that's been earned by cost basis investments as I mentioned. Adjusted earnings per share was $0.80 on a diluted basis compared to $0.66 for the same period last year, up 21% on a constant currency basis adjusted earnings per share was $0.81, up 23%. Year-to-date, adjusted earnings per share 265 per share on a diluted basis compared to 259 for same period last year, up 2% and up 8% on a constant currency basis 279.
GAAP net income for the quarter was $0.69 or $0.57 a share on a diluted basis compared to $0.27 or $0.22 per share on a diluted basis in Q3 of last year. Year-to-date, net income was 198 or 162 per share on a diluted basis compared to 165 or 135 per share on a diluted basis last year.
There were approximately 121.7 million shares outstanding on a fully diluted basis for the third quarter and on a year-to-date basis there were 122 million shares outstanding on a fully diluted basis.
Operating cash flow for the quarter was approximately 190 million, increase of 33% compared to 143 in the same period last year. The increase was primarily due to an increase in net income of 43.
Seasonally driven increase in deferred customer support revenue and active management of our working capital. Driving cash flow improvements continues to be a top priority. On the balance sheet at March 31, deferred revenues were 402 compared to 386 at June. And this increase is normal course.
Accounts receivable 266 compared to 284 at June 30 and our trade accounts payable stood at 44 compared to 16 at June 30, 2015. Year-to-date, the net positive change from these two working capital items is approximately 50.
Now to the external target model, reiterate the comments that I made last quarter. We are maintaining our fiscal 2016 non-GAAP operating margin target of 30% to 34% and we expect to land at the top end of the range.
Tax update, there is no news from last quarter, nothing to update you on. In terms of the dividends on April 26, the Board declared a cash dividend of $0.23 per share per shareholders of record on May 27, 2016, payable on June 17, 2016.
On April 18, we signed a definitive agreement to acquire certain customer experience software and service assets from HP, Inc. for approximately $170 million. The transaction is expected to close in the fourth quarter of fiscal 2016 and is subject to customary regulatory approvals and closing conditions.
This quarter, we also signed a definitive agreement to acquire ANXeBusiness Corp. for approximately $100 million. The transaction is also expected to close in the fourth quarter of fiscal 2016 and is also subject to customary closing conditions. We do not expect any meaningful revenues within Q4 from the acquisitions, but we will have some acquisition-related expenses.
Now, I’ll turn the call over to Steve Murphy. Steve?
Yeah. Hey. Thank you, John, and hello to everyone on the call. Let me touch on my first 100 days on the job. The first 100 days in my post as President of Open Text has been nothing short of spectacular. I’ve hit the ground running, and I’m energized to be here. I made it a priority to take time to listen, learn and act where appropriate. At Open Text, we have a culture of customer first, and we live up to it.
Since coming on board in January, I’ve met with more than a 1,000 customers, partners and employees in North America, Asia, Europe, the United Kingdom and Australia. Speaking at the Innovation Tour was a great opportunity to engage customers in a dialogue about Release 16.
My philosophy is that customers don’t buy from companies, but rather they buy from people. And I continue to be impressed with the high level of customer engagement that these in-city events deliver. The feedback is clear. With Release 16, we have the best products positioned in the right market with deep customer loyalty, reflected both in the amount of follow-on sales and retention of CS and cloud revenues.
My other big observation is looking internally. Open Text has a strong operations-oriented culture, which fits my management style well. There is opportunity to balance cost discipline with driving sustainable, organic growth initiatives.
Let’s talk a little bit about the quarter in review. I’d like to take a quick look at the quarterly results. We had a strong quarter for license sales, and I’m pleased with the performance of our customer support and cloud businesses. Professional services came in weaker than we had planned, and I’ll touch on our plans to improve this a little later in my remarks.
So some quick license stats. License revenue was up 6% year-over-year in constant currency. We had 10 on-premise license deals greater than $1 million, up from 3 in Q3 of last year. Average license deal size increased to $363,000 compared to $257,000 in Q3 of last year. The geographic split of total revenues was Americas 58, EMEA 33, and Asia Pacific/Japan 9.
On-premise customer successes in the quarter included PBS – the Public Broadcasting Service – Bosch, Diebold, Cancer Treatment Centers of America, Public Works and Government Services of Canada, government of the Northwest Territories, National Bank of Canada, Zeiss, Lenovia [ph], SMC Corporation of America and Cameron LNG. In terms of industry breakdown, financial, services and technology industries saw most of the demand. Okay.
Here are some quick cloud stats. Cloud revenue was up 2% year-over-year in constant currency. We had eight new MCV deals greater than $1 million, up from seven in both the same period last year and in last quarter. Cloud customer successes in the quarter included CIBC, The Government of New Zealand, Tetra Pak, DC Comics, and Standard Insurance Company.
We also added 17 new managed services customers in Q3 which brings our total managed services customers up to 920. And we had 20% MCV growth from 38 million to 46 million compared to the same quarter last year. Average MCV deal size increased to 426,000 compared to 317,000 same quarter last year.
Financials, services, consumer goods and technology industry saw most of the demand for cloud. Overall, I've a lot of confidence in both our account planning and sales execution in the field. We delivered a strong quarter in license, CS and cloud. That being said, professional services did not meet our expectations. PS revenues were down $5 million year-over-year in constant currency and negatively impacted our adjusted EPS results by approximately $0.02. This is partly due to product and geography mix in transition to Release 16.
We make note that we hired a new leader of services, Prentiss Donohue, who joins us from Oracle where he was the Group Vice President for North America Advanced Customer Services. Professional services is an important revenue stream for Open Text. And we expect performance to return to normal levels in the next two to three quarters.
Let me talk a little bit about Release 16. Something that’s exciting for the whole sales force and the company is Release 16. I'm focused on growing healthy and sustained organic license revenue for Open Text and convinced that Release 16 will help us achieve this. We are making key Release 16 investments both immediately and over the coming quarters to focus on customers, and market share gains through sales enablement and field readiness, customer upgrades, and competitive replacement.
Our customers see the world as hybrid. We listened and provided them with flexibility and functionality as well as hosting expertise to support their deployment initiatives. Open Text has a healthy ecosystem with strategic partners and system integrators, including SAP, Accenture and Deloitte that are both industry and regionally focused. In many cases, it’s better to have a partner in a service region in which we don't have a presence.
We support their initiatives with significant marketing and resources. We will have a large presence at SAPPHIRE, SAP’s user conference and I personally look forward to being there and participating in that even, promoting Release 16 and strengthening our relationship with SAP and our SAP customers.
Let me touch briefly on acquisitions. We announced that we expect to close within the fiscal year, namely the assets of Hewlett-Packard, Inc. and ANX. While it’s early to talk about on-boarding the customer facing areas of these businesses, Open Text remains committed to customer care and satisfaction. And these principles will carry over when we welcome new customers to the Open Text family.
So let me summarize before I hand over to Mark. Before I have over to Mark, a few key points. We delivered strong license performance, strong margins, strong income, and strong cash flow. Professional services did not meet our expectations and I have taken actions including putting a new leader in place.
Release 16 carries us into a new product cycle for fiscal 2017. Its early days but I'm really encouraged excited by the level of enthusiasm and deal activity around it. As I said earlier, customers don't by from companies, but rather they buy from people. I’ve observed first hand that all around the world the customers like us and trust us. It's a huge competitive advantage. I look forward to meeting many of you at our Investor Day in New York on May 12.
Over to you, Mark.
All right. Thank you, John and Steve. There are two topics I'd like to cover today, M&A and Release 16. Before I get into those details let me start with a few comments on our Q3 performance. There are many metrics, but the one metric above all is cash flow. As cash is king. We are very pleased with our record operating cash flows of $190 million and the execution that supported it.
The team delivered these results with a $15 million drag on revenue due to FX a very busy quarter in deal flow and execution while completing and launching Release 16 while strengthening my leadership team on 12% left operating expenses I know in constant currency OpEx was $179 million this quarter compared to $203 million last year same period.
We delivered these results on a growing mix of revenue that is recurring in cloud based, recurring revenues were 85% to total revenues and cloud revenues were 2.3 times larger than our licensed revenues. And we delivered this while expanding adjusted operating margin 480 basis points again in constant currency. Beyond the numbers and the 15% dividend raise, the company got stronger in Q3. And it was a wonderful thing to see.
On to my first topic, mergers and acquisitions. M&A is our leading growth driver and it's central to our business and financial model. We are generating expanding cash flows that will be reinvested into acquisitions at market leading rates of return. There are hundreds of assets available within the enterprise information management market and our pipeline of targets is increasing.
Open Text is a consolidator and as a culture of proven history of integration. Our M&A model is differentiated from others for many reasons, but let me just highlight two, an integrated go-to-market and integrated engineering organization. We acquire businesses within our enterprise information management market strategy using our proven approach to M&A.
We then operate those businesses leveraging our intelligent growth business system creating superior products, customer success, and shareholder value. Over the last 10 years Open Text has delivered a cash flow CAGR of 25%. We are an industry consolidator, have completed over 50 acquisitions, and perhaps it's our Canadian roots. We have a culture of integration and we seek value. The enterprise information market is highly attractive. That as revenue scale it is growing and provides transformative capabilities for customers.
Its addressable market is well over $20 billion in customer spending with a greater than 7% growth rate and garnishes high profits unlike other hardware software or services markets. Our market is reshaping itself today, and Open Text is shaping its future. As I mentioned, there are hundreds of acquisition targets and the EIM customer base is Marquis.
By Marquis I mean there are larger deal sizes, the deals are more transformative and there’s low credit risk given the Marquis nature of the customers. EIM is at the core of long term trends and purchasing decisions, digital, information governance, business networks, cloud, predictive analytics and security.
M&A models run in a continuum. From what I like to call platform operators to asset acquirers, companies such as Danaher, Roper, Amitech, Blackstone, KKR, Constellation and Open Text, have M&A models at their core and fall somewhere in this continuum. Platform operators pursue M&A led businesses with their strategic market theses. Purchase assets within that market strategy and then drive deep value to integration and innovation.
Asset acquirers purchase individual assets and operate and optimize them as standalone businesses. Open Text is a platform operator. And we believe in the value of an integrated salesforce, integrated engineering, and integrated operations. And for our business, this should lead to the greatest cash flows, highest cash flow multiples, and thus maximum shareholder return. Why? Because the model scale.
Our asset targeting methodology is all about unlocking value. We evaluate businesses within the context of our EIM strategy and look to fill functional white spaces, vertical capabilities for key geographic expansion opportunities.
Ideal targets have special situations that would benefit from the Open Text intelligent growth business system and scale. We value recurring revenues, past the higher margin and strong cash flows.
We are attracted to strong leadership teams, solid products and leading distribution models and we are very capable of entering a challenging situation where one or more of these areas need immediate attention. What we target is supported by our proven methodology. We have a seasoned and dedicated in-house corporate development team from all the way from sourcing to closing which include diligent deal closing, asset integration and monitoring first year performance.
Cost synergies are more preferred to revenue synergies. Our business cases are mostly based on cost synergies and cash models. We prefer cash flow over higher revenue growth and set minimal thresholds on AOM, AOI and cash flows.
This is what we mean when we say onboarding to the Open Text target model. Our internal financial models have simple and clear cash-based metrics on IRR, pay-back, terminal values, and other key metrics.
Day one integration is a critical element of success. We have over 3 billion in accessible capital to deploy in the next few years. We arrive at the $3 billion number by adding together our current cash on hand plus future annual operating cash flows, new cash flows from acquired businesses, available debt within our conservative debt to EBITDA ratio of three times, less our potential dividend disbursement and CapEx investment.
Our two most recently announced acquisitions certain CEM software assets from HP Inc. and ANX are write-down our M&A power alley. The HP assets will extend our leadership in CEM and ANX adds training grid and cloud services capabilities in healthcare, transportation, and auto.
Valuation meets our traditional methodology. The HP assets will be on our operating model within 12 months. ANX will be in our operating model day one. High recurring revenues and Marquee install base under our leadership and distribution weaken a lot more value and these two acquisitions will ultimately be cash flow oriented.
With these two acquisitions, we expect to on-board between 115 million and 125 million of new revenues in fiscal 2017. The acquisitions are expected to close in Q4. We do not expect, as John said, any meaningful revenues from these acquisitions within Q4, though we will have some acquisition-related expenses.
Lastly, within our M&A -- lastly, with our M&A capabilities expanding and our target pipeline growing, it is our intent to close and integrate more transactions at a more predictable pace.
We will remain disciplined value buyers, cash flow oriented; patient capital allocators, but steady and measured wins the race. I expect to deliver more transactions at a more predictable pace in the coming quarters ahead.
On to my second topic for today, release 16. Release 16 is now available to our customers and partners and the early feedback is very favorable from our customers, such as BNSF railway, Oxford Properties, Phillips 66, and Bell Canada. It is the most complete and integrated platform for digital transformation in the industry as far as we can see.
Release 16 is a platform to drive organic growth in the coming years and as a result of our approach to innovation and integrated and sustained engineering. The company focus now turns to enablement and adoption. Release 16 is a singular platform for the management, analysis, and exchange of enterprise information enabling digital transformations.
One platform to manage all information, digital experiences, and processes; one platform for predictive analysis; one platform to exchange information through business networks, business-to-business, cloud-to-cloud, and machine-to-machine; hybrid both on-premises and in the cloud.
It is the key platform to enable the divisionalzation of key enterprise processes, to enable disruptive business models, and to deliver the next-generation of information and process-based applications. Release 16 provides for many on-ramps for growth. New customers, competitive replacements, upgrades to new modules and full suites.
New and expanded partnerships such as Accenture Digital and ENY to help bring Release 16 to their customers. New vertical opportunity like healthcare transportation and logistics; new adoption of the business network, and analytics and predictive analytics everywhere within our suites.
Customers purchasing enterprise systems make decade-long decisions. The market is changing real-time and customers will look for stability, certainty, long-term commitment to innovation, and a technology partner that they can count on, and that is Open Text.
Just over the last 90 days, we have seen Lexmark and SiteCore being sold as well as the pieces of SDL. We have acquired core inter-woven assets as well as ANX. Given the early positive reaction to Release 16, the changing market landscape, we want to deliver more features and capabilities faster at a defined and predictable series of Enhancement Packs. We will follow Release 16 with a series of Enhancement Packs or EPs. Release 16 EP1 is scheduled for Q2 fiscal 2017, EP2 for Q4 fiscal 2017, and EP3 for Q2 fiscal 2018.
These Enhancement Packs will be available on-premises and in the Open Text cloud and what will follow the EP series will be project BAM.
Let me highlight two very important aspects of the ECP initiatives. EP1 will include Extended ECM for Salesforce. What we have completed for SAP and Oracle, we plan on delivering for Salesforce. EP2 will include our next generation of analytics, our cognitive release. Actually, we’ll be supporting Hadoop and Spark, Apache, immediately enabling thousands of open algorithms in a developer platform for customers to create their own algorithms.
In many ways, IBM Watson is a very closed and a very expensive platform. That sledgehammer is not needed for the majority of predictive workloads that we can see. In EP2, we intend to provide an alternative to IBM Watson.
This is the time to invest and go faster. Where other companies are slowing their investments, deinvesting altogether, being sold or cannot make a dollar of profit, customers should have full confidence in choosing Open Text for their digital platform in their next decade of infrastructure investment.
I’m very excited about the opportunities of Release 16, Extended ECM for Salesforce, and our cognitive – our future cognitive capabilities. We’ll talk more about Release 16, the EP series and BAM at our May 12 Investor Day in New York City.
Let me spend a moment on the Open Text cloud. The Open Text cloud consists of three elements – managed services, number one; number two, our trading grid and value-added network; and number three, SaaS applications.
We are approaching a 1,000 managed service customers, and we offer managed services across all our solution pillars with Release 16. Notable wins within the quarter include CIBC, DC Comics and Government of New Zealand. It is an important growth area for the company. Cloud 16 added new key logistics and healthcare protocols. Our ANX acquisition will add key vertical capabilities to our value-added network and trading grid.
As it relates to our SaaS applications, all customers renewing maintenance, all their cloud services agreement at par value, will now receive equal usage rights for free on Open Text Core. This new program will go live this quarter. We think there are approximately 10 million end users we can attract to Core, while providing even more value to our customer service and maintenance programs and revenue streams.
Once on Core, customers can upgrade to more capability or capacity and go from premium to paid. This program will enable customers to seamlessly and cost effectively integrate on-premises and in the cloud ECM solutions from one vendor. Only Open Text can enable this as a single provider and is the only vendor in the market today integrating file sharing, sync and collaboration technologies, with core enterprise ECM records management and governance.
As for our overall financial model, as we onboard more cloud revenues, we have four years and yet another quarter of results. And the results speak for themselves. As we onboard new cloud revenues, we continue to expand our adjusted operating margin, which was up 480 basis points this quarter.
Looking towards our fiscal 2020 aspirations, we expect our mix of business to be 50% from the cloud, over 90% of our revenues recurring, and our adjusted operating margins between 34 to 38%. And we expect to achieve this, while our license business remains constant on an absolute basis. Sorry, if I keep repeating myself over and over again on these collective points. I think it's very important to understand our financial model and four years of data points and yet another quarter.
In summary, it's an exciting time. The market is reshaping itself and Open Text is defining its future. Our M&A with our intelligent growth business system is a proven approach to delivering market leadership and shareholder value. M&A will be our leading growth driver for the years to come.
As I said earlier, with our M&A capabilities expanding and our pipeline growing, it is our intent to close more transactions at a more predictable pace. We remain value buyers, cash flow oriented, patient capital allocators and steady and measured wins the race. We delivered record operating cash flows in Q3 on 12% less operating expenses.
Release 16 is now available to customers providing a clear choice in the marketplace as to which vendor customers should choose. Release 16 has potential on-ramp to grow that Steve and the field are driving over the coming quarters.
Some of those on ramps include M&A, both announced in any future transaction, Release 16 for new customers, upgrades and more adoption via suite analytics in the business network, key vertical opportunities in financial services, healthcare, transportation, public sector, expanded partnership such as Accenture, and E&Y, EP1 with Salesforce, managed services and capturing our install base with core. And in general we believe customers will look towards innovation, certainty and stability and Open Text will be a leading consideration for the digital transformation needs.
The EIM segment is being recognized for its transformative capability. It's large, growing and there are hundreds of potential targets for us and we have a proven approach to M&A, the capital to deploy and the leadership team ready to execute and go capture that opportunity.
I am in my fifth year as CEO at Open Text, I'm honored and humbled every day to lead the business. I realigned my leadership team and my responsibilities approximately 100 days ago and that realignment is already bearing fruit in our results and our strategy and our announced plans. My energy, passion and optimism for Open Text has never been stronger.
I hope you will join us on May 12th in the New York City for our Annual Investor Day. We will go into more depth on the company, strategy and plan. We have a solid day planned where myself, John Doolittle, Stephen Murphy and Muhi Majzoub will be presenting and available for Q&A.
With that I'd like to turn the call over to the operator for your questions.
Thank you. [Operator Instructions] Our first question is from Richard Tse of Cormark Securities. Please go ahead.
Yes. Thanks. I'm not sure if this is a question for Mark or Steve, but I wondering if you can elaborate little bit more on the professional services. Did you say that the pull back was due to a pause and customers waiting for Release 16 to come out, or maybe give us bit more color on that, please.
Yeah, hey, Steve here. So I think that the pause itself is a little bit of a lack of managerial attention. I think that’s part of it. I think there are places like EMEA quite frankly where we’ve got backlog de-burned through that could have been burned through and wasn't.
So I look to that and then seasonally Q3 has been a weak quarter for us and I think that a lack of management attention associated with what I just described in. The inability to burn through that backlog was part of what affected it.
And I do expect it’s going to take two to three quarters to get this business back on track. Those are the biggest things associated with the TS lag. Mark is there anything to add to that?
No. Not at all.
Okay. And Mark, you talked a lot about M&A and the predictable pace, is that because you sort of put in place of process now or things just sort of coming to you given the pricing aren’t better, maybe give us a bit more color on that, please?
Yeah, sure thing, Richard. So it’s a sort of a combination of items. One is we've expanded our in-house capabilities. We have more attention on it from the leadership including myself. And I also think the market conditions are more favorable to buyers today.
So I think those things coming together and has created a kind of a, you know, unique opportunity in the near term here for the company. And M&A has always been at the heart of what we do, right? So I would say with the expanded capabilities of the team, more time for myself and others and sort of market conditions, that we're putting more of an emphasis on it.
Okay. And just one last one on the cash flow there was a big step-up in cash flow. So should we take that as being a kind of a -- an increase in your former run rate here, or was this – it doesn't sound like it's a one-off, but maybe give us a sense of where that could be?
Yeah, Richard, it's John. Couple of things, one is the, you know, the bulk of the increase was related to the increase in net income. And then secondly, we continued as I said on previous calls to focus on working capital and driving improvements there. So there is more room to improve on working capital, but those are the two big contributors.
Great. Thanks, guys.
Our next question is from Steven Li of Raymond James. Please go ahead.
Thank you. Maybe I will start with a question for John. So when I look at the sequentially Q2 and Q3, so your revenue base is lower in the March quarter but your operating expenses is higher this quarter. So John, are there any non-recurring costs on the expense side, or is it more increasing investments you're making?
Yeah, Steven, thanks for the question. So we talked last quarter about increasing our investments and we’ve been doing that as we prepared for Release 16. So we have increased some of our headcount and sales in engineering and other areas. And there is some degree of seasonality in there as well. So we had low vacation expense last quarter and that would have increased this quarter. So it's a combination of increased investment and better seasonality on the expenses.
You expect it to be sustained, John, or does it taper off after some point?
Which part, Steven?
The investments for Release 16?
I would expect us to continue to invest over the next couple of quarters, definitely.
Okay. And Mark maybe a question for you, I know its early days but the customers you highlighted for Release 16, like Bell, Canada, any of those customers have been competitive displacements?
I’d say that the early wins are more of within our install base, Steve. We – as we get towards enterprise world, its sort of a natural progression. We're going to educate our sales force, we’re going to educate our partners, we’re going to educate our install base, and we'll then kind of fan out from there to more competitive replacements.
So, as we march towards enterprise world in July. We'll have quite a bit of news around competitive replacement programs. It's sort of like a rolling thunder program. Its 50 employees, install base and then new customers and competitive replacement.
All right. Great. Thanks.
Our next question is from Paul Steep of Scotia Capital. Please go ahead.
Great. Mark, thanks very much for the description and the discussion around M&A, I think it articulates what lots of us have known over the years about Open Text. The one part I'd be curious about, though is, in the context of how you’re thinking about deals, particularly large transformational transactions, would you differentiate the hurdle rates across your deal portfolio and then I’ve got a quick follow-up.
Yeah, it's a good question. Deals, opportunities, really come in small, medium and large packages. And they also come with different structures, both HP Inc., and ANX were carve-outs by first, maybe standalone companies and share purchases.
As you move up in deal size, yeah, I think some of the metrics do change a bit. Our philosophy doesn't change around value and cash flows, but theoretically the larger the asset typically a higher valuation is associated with it, which means we have to look a bit more deeply on integration and cost synergies.
But theoretically the larger, this is just a theoretical M&A statement, that the larger the deal size typically that scale comes with a slightly higher valuation. But our philosophical view of value and cash flow generation won't change.
Great. I guess to follow on and maybe shift to Steve a little bit, we talked already about the PS change you've made. Are there any other changes or realignments in field operations that you've executed at this pointer? Or is it fair to think that you’d wait till sort of sales kick-off towards the end of the year?
Yeah. Hey, good question. So the answer is, that’s the big one, as far as bringing in someone from the outside to run PS. And stability is really my focus right now. So identifying some room to improve PS was clear and just maintaining stability with what is a, quite frankly, a really solid team with some good products I think has a opportunity to pay some really big dividends. So, short answer is, that's about it for now and we're going to focus on continuing to do what we do well.
Great. One last quick clarification, not to leave John out, because I know he’d be disappointed. On R&D…
So you’re going to talk about the cash flow at 190.
This would relate to the forward which would be, Mark talked a lot about R&D investment into next year, great development sort of going to happen for customers. Is it fair to think that those investments are all going to be within the existing envelope that we've been all thinking about? Thank you.
Yeah, Paul, it is. We've I think given a target model of 10% to 12% on R&D and Muvi has done a great job managing with that envelope, and he has been increasing his headcount but redistributing a lot of that in lower cost jurisdiction. So we look at the overall expense holding pretty steady but he has actually been able to do that and increase headcount and I would expect that to continue.
No change at this stage to the model.
Our next question is from Blair Abernethy of Industrial Alliance Securities. Please go ahead.
Thanks. Just two things. First, Mark, I wonder if you can give us a sense, or Steve, of just sort of what you're seeing with suite 16 in the marketplace? How many weeks have you really been out there where you're actually selling it and, you know, what are the kind of -- what areas of the suite are you seeing the most traction with?
Yeah, so we've got -- we'll say a couple of months of exposure putting the product out in the marketplace, and content management, whether it be a consumer package good company, or a bank, those are two examples where we're seeing customers coming and say, yeah, we would like to give it a try and understand how we would apply the technology, how quickly can we implement it and at what price point. So definitely within financial services and banking and manufacturing, we have seen uptake, significant uptake, government financial services and also the public sector or places where we're seeing content management, also some business process management solutions that customers are requesting. Anything to add to that, Mark?
Year, Blair, thanks for the question. And let me add to Steve's comments. I'll injecture on the competitive landscape a bit. You know, we compete with IBM mainly in file net and in sterling commerce. And, you know, 16 quarters of revenue decline, boy, it must be getting tiring, I have to tell you that. On the EMC side, they sold off their cloud assets, they have not innovated, and they are just core ECM. So they're not ECM with Apps, CCM with SAP, they are not EIM, and we're competing very effectively against them.
Adobe, we are winning in the digital asset management space, web experience management space and customer communications management. We just got stronger with the assets that we announced with Interwoven. You have FPL being sold in pieces by Florida, went to private equity. Lexmark, you know, who knows where Cofax and ReadSoft will end up and, of course, we still see a fair amount of disruption on the archive side with Symantec.
So its early days, as Steve said, with Release 16. Actually next quarter will be our first full quarter of GA , but I tell you I have never felt better on the competitive side where, you know, if you wind back 20 years in ERP, there were 100 ERP competitors and then it got down to 50 and 20 and 10 and J Bop’s and two. Release 16 is a pivotal moment with these market conditions that I think we're getting down to three to five main competitors in this area.
Okay. That's great. Thanks for that, Mark. And John, just I wonder if you can touch on maintenance renewals in the quarter, customer support revenue was down a little bit sequentially. I suppose most of that is FX, but just can you talk a little bit about core license renewals, maintenance renewals, and pricing.
Yeah, Blair, holding steady at around 92% mark, no change in the quarter. And we were up in constant currency in customer service. So, the FX is the reason that you pointed out that's accurate.
Okay, great. Thanks, guys.
Our next question is from Paul Treiber of RBC Capital Markets. Please go ahead.
Thanks very much. I just wanted to focus on the go-to-market strategy for Release 16. A couple years ago, you guys went through a large sales force expansion. How do you look at your sales force at this point and what are some of the investments that you're making from a go-to-market point of view?
Yeah, hey, Steve here. So, a couple of things, we're not going to give any specifics on sales force expansion, but it is an area of investment. And I'm not going to any KPIs, but there is a robust opportunity to expand with quality where it makes sense and with Release 16, there are plenty places like I just said financial industry, consumer package goods, government where we continue to grow and expand.
So, we're a direct sales force and we will continue to be a direct sales force. We will partner closely with the big GSIs, the global system integrators where it makes sense, and we'll continue to put a lot of effort and investment in SAP. That relationship has borne fruit for us and I see that it will continue to do so and will do that with a focus on quality and on Release 16. From an industry vertical standpoint, I won't repeat myself, there are few with 16, we already see it having a great fit. There was a second part to your question, too. What was it?
Broader go-to-market strategy around Release 16.
I think that's it. I think I outlined it as far as the GSIs and SAP. That's about as broad as I think it gets for us. I think that as far as enabling the sales force and making sure that they have enough product knowledge to be capable, we've gotten very systematized around the different modules and tracking and training and making sure that our sales force can take that, the direct sales force.
I think that having a value-based sale -- the actual value proposition being well-defined by vertical is another area of focus for me. I've got a lot of experience based on the places I've been where we can take a -- basically looks like Excel Spreadsheet that says this functionality which is unique within Release 16 is going to equal this much in value to you depending what vertical industry you're in. And using that as part of the pricing process, the discount is little as possible. That's another method we've introduced with Release 16 by industry vertical.
Secondly, could you speak to the opportunity around Salesforce and your partnership there?
Yeah, I'll take that one, if that's right. So, -- thank for your question, Paul. And just to amplify a couple points that Steve made. I think what's new with Release 16, are some of the large global SI partnerships that Steve and his team are building.
What's new are kind of key vertical opportunities. And probably a third one that's new that has come along to actuate our embedded opportunities that Steve and the team are working on. So, those are sort of the new opportunities.
And on that vein of large software partnerships like SAP, we see an opportunity with salesforce. The work we've done with extended ECM, we are going to extend into sales force, with EP1 and provide full enterprise content management hosted in our cloud, cloud to cloud, with salesforce, you know, fully integrated into salesforce.com and a modern HTML5 user interface and our full extended document management, our archive, records management and governance capabilities that will be integrated to salesforce with EP1.
Okay. Thank you. I'll pass the line.
Our next question is from Eyal Ofir of Dundee Capital Markets. Please go ahead.
Thanks. I just want a quick question on Release 16 here in terms of the early days. Are you guys seeing more demand on the SaaS side or on the license. Maybe you could talk to what the customer feedback is like and what type of take-up you're seeing thus far?
Let me take that first, which is – we're not really seeing a shift of SaaS or, you know cloud – subscription versus on-prem kind of shift. We still see the world as hybrid, the best way to describe it is a ultimate 50-50 split.
You know, in fact, we had two customers last quarter, who went from our cloud services to back on-prem. And one went back on-prem, because they've done the economic model.
They have been in our cloud for a couple years, and having a great service from us, and they wanted – they were looking at a multi-year model and just felt that for them and their usage that economically it was better to be on-prem.
We had another customer who had a security event unrelated to us, who had decided that the system should be in-house versed in a cloud. So we actually had two customers that I know of, there may be more, who went from cloud back to on-prem last quarter. We view the world as hybrid, I don't think Release 16 will change the dynamic that the world is 50-50.
Okay. I appreciate that. Just on the acquisitions as well, you talked about integrations and onboarding your operating model. In terms of actually getting them onboard to your platform, how long does that take for each acquisition?
I am sorry, Eyal. Could you repeat the question?
Just to get them onboard, I assuming the plan is for both acquisitions is to get them on to your platform, technology as well, not just the financial model. So I was just wondering if it is the same time lines or if it is different and how long it would take?
On the financial model we're looking for the HP assets within the first year, and on the ANX day one. On the technology…
I meant technology – sorry.
Fair enough. On the technology platform our view is really kind of the next release cycle. So we want to be able to get the asset onboard, get them integrated day one, and then on the next release cycle have them more in line with our technology standard.
So I don't know if probably in this road map around EP2, that they would be more on our technology platform. But conceptually within the next release cycle, which could be 12 to 18 months, that would like them more aligned with our tech staff.
Okay, great. And before I pass the line, last question for me just on documentum [ph] the rumors MC looking to sell it, just wanted to get your thoughts on it and how are you guys looking at that asset as well? Thanks.
Thank you for that last question. And we won't comment obviously on rumor or speculation. But we appreciate the question. With that, I think we will wrap up the call and we look forward to hosting everyone on -- at our Investor Day in New York City on May 12, and hope to see you there. Thank you very much.
This concludes today's conference call. You may disconnect your lines. Thank you for participating and have a pleasant day.+
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