Blackbaud (BLKB) Michael Gianoni on Q1 2016 Results - Earnings Call Transcript

| About: Blackbaud, Inc. (BLKB)

Blackbaud, Inc. (NASDAQ:BLKB)

Q1 2016 Results Earnings Conference Call

April 28, 2016, 08:00 AM ET


Mark Furlong - Director of Investor Relations

Michael Gianoni - President, Chief Executive Officer

Anthony Boor - Chief Financial Officer & Executive Vice President of Finance and Administration


Tom Roderick - Stifel

Steve Ashley - Robert W. Baird

Kevin Liu - B. Riley & Company

Ben McFadden - Pacific Crest


Good day and welcome to the Blackbaud 2016 First Quarter Earnings Conference Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Mr. Mark Furlong, Director of Investor Relations. Please go ahead, sir.

Mark Furlong

Good morning, everyone. Thanks for joining us today on Blackbaud's first quarter 2016 earnings call. Today we will review our Q1 financial and operational results, provide commentary on our performance in the context of our five point growth strategy, and discuss progress against our 2016 financial guidance and long-term aspirational goals.

Joining me on the call today are Mike Gianoni, Blackbaud's President and CEO, and Tony Boor, Blackbaud's Executive Vice President and CFO. Mike and Tony will make prepared comments and then we will open up the line for your questions.

Please note that our comments today contain forward-looking statements subject to the risks and uncertainties that could cause actual results to differ materially from those projected. Please refer to our most recent Form 10-K and SEC filings for more information on those risks.

We believe that a combination of both GAAP and non-GAAP measures are more representative of how we internally measure our business. Unless otherwise specified, we will refer only to non-GAAP financial measures on this call.

Please note that non-GAAP financial measures should not be considered in isolation from or as a substitution for GAAP measures. A reconciliation of GAAP and non-GAAP results is available in the press release we issued last night and available on our investor relations website.

Before I turn the call over to Mike, I will briefly cover our upcoming investor relations activity, which can be found on the events section of our investor relations website. Investor day will be held in conjunction with our user conference, BBCON, on October 27 in Washington, DC. Registration is now open and available on our website.

During the second quarter our team will be attending the following conferences: SunTrust in San Francisco, Jefferies in Miami, B. Riley in Hollywood, Bank of America Merrill Lynch in San Francisco, Stifel in San Francisco, RW Baird in New York, and Citi in New York. We will also be meeting with investors in Chicago and Milwaukee. Please reach out to investor relations if you're interested in connecting at one of these events.

With that, I'll hand the call over to Michael.

Michael Gianoni

Thanks, Mark. Good morning, everyone. Thanks for joining our call today. I am pleased to say that our first quarter financial performance was a solid start to the year and positions us well to achieve our full-year 2016 guidance that we issued in February. Tony will provide more detail on our financial results and, as usual, I will provide an update in the context of our five point growth strategy. So let's jump right in.

The first of our five strategies is what we call integrated and open solutions in the cloud. This initiative is highlighted by the introduction of Blackbaud SKY, which is our modern, integrated, and open cloud.

Blackbaud SKY serves as the foundation of our next-generation solutions and is already delivering an unprecedented level of innovation to the philanthropic sector. It combines infrastructure, processes and pre-integrated services like payments and analytics, to deliver total solutions and help our customers achieve their highest potential.

To demonstrate the impact, we've commissioned a Forrester study of Raiser's Edge NXT, our first product to leverage the full capabilities of Blackbaud SKY. The outcome for our customer, Habitat for Humanity of Dane County, was increased revenue, reduced costs, streamlined processes, the elimination of multiple vendors and an ROI of 181% with a short four-month payback period. This is exactly the type of result Raiser's Edge NXT was designed to deliver and a great example showcasing the capabilities of Blackbaud SKY. I am pleased to report that Blackbaud SKY now powers six of our next-generation solutions.

Our eTapestry solution for small customers is one of these six. We now have almost 7,000 customers in the Blackbaud SKY environment. eTapestry now offers our customers a complete set of capabilities out of the box to take on a full range of fundraising needs. And just like Raiser's Edge NXT, eTapestry is designed to be mobile first.

The proliferation of giving using a mobile phone or tablet underscores the need for responsive design, which is device-agnostic technology. In 2015, giving on a mobile device made up a mere 14% of total online giving, but grew an impressive 45% year-over-year according to our own customer data.

Our products are ensuring a seamless experience for both fundraisers and donors, whether they are using a phone, tablet, or computer. Our eTapestry customers are also sharing a common user experience with SKY UX.

Our new, always-modern user interface found in other Blackbaud SKY solutions like AngelPoints and Blackbaud Outcomes. SKY UX is now generally available to our customers and partners on GitHub after a very successful early adopter program.

Later this year our next-generation Luminate product will also adopt SKY UX, moving us closer to SKY UX becoming the standard across our portfolio. In fact, our entire product portfolio is steadily incorporating elements of Blackbaud SKY.

For example, some of our products now leverage pre-integrated wealth analytics services and pre-integrated payment services and our K-12 private school solutions provide an unparalleled mobile experience for parents, students, and teachers.

We have a very rich set of solutions in our portfolio with robust capabilities and we are steadily marching towards a common set of infrastructure, processes, and pre-integrated services.

We are also currently in the technical preview stage of SKY API, in advance of our early adopter program. Sky API will give Blackbaud customers, partners, and other application developer’s access to industry standard REST open APIs and a comprehensive set of resources which will allow them to customize, integrate, and extend the functionality of Blackbaud solutions. We're excited about the possibilities an open environment presents for Blackbaud, our customers, and our partners.

Now let's turn to our second strategy, which is driving sales effectiveness. We are committed to creating a world-class sales organization at Blackbaud to drive healthy top-line growth and penetrate our large market opportunity. To that end, we've established a sales excellence program and recently hired an experienced leader to head up this effort.

The focus of this program is to enable our expanding sales teams with the talent, processes, and tools to accelerate our revenue growth and improve effectiveness. We have already laid some of this groundwork and these early efforts have contributed to the traction we are experiencing in the market.

Our organic revenue growth, on a constant currency basis, accelerated from the low single digits in 2013 to 7.1% in 2014, 7.7% in 2015, and is expected to exceed 9% in 2016 using the midpoint of our guidance.

We have a considerably large runway ahead. In 2015 we were roughly 10% penetrated into our $6.3 billion total addressable market. We anticipate adding sales headcount in 2016 and have introduced an indirect sales channel in Q1 that brings VARs into the Blackbaud Partners program.

We also continue to expand our Customer Success program, which further separate sales from account management, now focusing 100% of our sales organization on selling. Our customer success teams take a proactive approach to ensure our customers are fully realizing the value of our solutions and leveraging the complete set of capabilities Blackbaud offers.

This effort will continue to drive customer loyalty and retention and is an investment in our customers, which we believe will result in increased referrals.

Now let me turn to our third strategy, expansion of our total addressable market or TAM. Our approach is to expand TAM through acquisitions or solution expansion into new or near adjacencies.

We executed this strategy in 2014 with the acquisitions of WhippleHill and MicroEdge and again in 2015 with the acquisition of Smart Tuition. The results of these three acquisitions added incremental TAM of over $1.5 billion in complementary best-in-breed cloud solutions to our portfolio.

We remain active in the evaluation of acquisition and solution expansion opportunities that would complement our cloud portfolio, accelerate revenue growth, and be accretive to margins and expand our total addressable market.

Our fourth strategy is to focus on streamlining operations. We have largely completed the consolidation and upgrade of our back-office by moving from over 30 disparate software platforms that ran the major operations of the business to less than 10 best-in-breed cloud solutions today.

A recent example is the installation of a modern human resources platform which eliminates multiple disparate vendors, simplifies and automates processes, and for the first time, allows us to manage all global Blackbaud employees on a single platform.

The efficiencies gained are significant and our scalable infrastructure prepares us for further organic business growth and the integration of future acquisitions. We will continue our work to optimize these recent infrastructure investments throughout the remainder of 2016 and into next year.

Our final initiative is the execution of an operating margin improvement plan. Our long-term aspirational goal calls for annual operating margin of 20.5% to 23.5% at 2014 constant currency by the time we exit 2017. This is a 300 to 600 basis point improvement from our baseline of 17.5%, which was the midpoint of our original 2014 guidance.

We extended 2015 with 160 basis points of margin improvement over our 17.5% baseline on a constant currency basis. In 2016 we anticipate additional incremental improvement by delivering a full-year operating margin around 20% when normalized for currency.

Overall, I am very pleased with our progress in the quarter. The solid financial performance is a direct result of execution against our five-point growth strategy. Our strategy is widening the gap between Blackbaud and the competition, ultimately delivering greater value to our customers.

I'll now turn the call over to Tony to cover our financial performance in greater detail before we open it up for Q&A. Tony?

Anthony Boor

Thanks, Mike. Good morning, everyone. Pleased to report that we had a solid start to 2016. I will direct you to yesterday's press release and the supplemental materials posted to our investor relations website for the full detail of our financial performance. I will focus on key highlights today so we can get your questions.

Our first-quarter revenue was $171 million, an increase of 13.6% over 2015 or 8.6% on an organic basis adjusted for currency. We are well-positioned to achieve our full-year revenue guidance, anticipate increasing our organic revenue growth for the third consecutive year and are tracking towards the high-end of our long-term aspirational goal range of 6% to 10% annually, adjusted for constant currency.

Recurring revenue represented 79.4% of total revenue, which is 320 basis points higher than the Q1 of 2015, and grew 10.3% on an organic basis before adjustment for constant currency.

The growth in our recurring revenue continues to be fueled by subscriptions revenues, which accounted for 57.7% of total revenue in Q1. This is an 830 basis point improvement over Q1 of 2015 and growth of 18.6% on an organic basis before adjustment for constant currency.

The growth in subscription revenue is a result of our strong and balanced performance across the cloud portfolio, migration of our mid-market customers to NXT, and the incremental revenue from the acquisition of Smart Tuition, which we estimate will contribute $40 million to $50 million for the full year of 2016.

I will point out that our maintenance revenue continues to decline sequentially as we migrate our installed mid-market maintenance base to subscriptions with NXT.

Turning to profitability, our gross margin was 59.6%, which is a 120 basis point improvement over Q1 of 2015 before adjustment for constant currency. Please note that we have added to our supplemental investor materials to include greater GAAP and non-GAAP reconciliation detail and now disclose our non-GAAP gross margins by individual categories to give you a more detailed picture of our performance.

We generated operating income of $31.6 million, representing an operating margin of 18.5% and diluted earnings per share of $0.42. These results are tracking in line with our plan and we are reiterating our full-year guidance.

Our operating margin adjusted for 2014 constant currency was 19.0%, which positions us well to achieve our long-term aspirational margin improvement goal of 20.5% to 23.5% by the time we exit 2017.

Moving to the cash flow statement and balance sheet, our cash flow from operations was $0.1 million, which is a decline compared to $4.2 million in Q1 of 2015. Q1 is historically our lowest quarter for cash generation.

Our Q1 2016 cash flow from operations was pulled down a bit by our strong 2015 performance, which drove an increase in accrued bonuses paid out in Q1 of this year.

We remain on target to achieve our cash flow guidance for the full year as well as a long-term aspirational goal of $500 million to $550 million in aggregate cash flow from operations by the end of 2017.

We spent $13.6 million in CapEx towards necessary innovation and infrastructure investments to support our move to the cloud. We also paid out $5.7 million in cash dividends to shareholders and ended the quarter with $410.3 million in net debt.

Our capital strategy calls for a debt-to-EBITDA ratio of less than 3.5 times and we currently stand at less than 2.8 times, inclusive of debt we incurred to acquire Smart Tuition in Q4 of last year.

Turning to our full-year outlook, as Michael mentioned, we are reiterating our 2016 guidance that we shared in February. Our 2016 guidance builds upon our solid financial performance in 2015 and, once again, represents strong double-digit growth across each category, inclusive of foreign currency headwinds and the first full year of our mid-market cloud transition to NXT.

We expect total revenue of $725 million to $740 million; operating income of $141 million to $147 million; operating margin of 19.4% to 19.9%; diluted earnings per share of $1.90 to $1.98; and cash flow from operations of $145 million to $155 million.

Based on the latest foreign currency rates, we are estimating a revenue headwind of $2 million to $3 million on the year, which equates to a negative drag of approximately 35 basis points on our organic growth.

Our estimated impact to operating income is approximately $1 million to $2 million, resulting in an operating margin drag of approximately 10 basis points for the year.

In summary, we've carried the positive momentum from 2015 into 2016 and have executed well against our strategic plan. Our performance is ramping as a result of the investments we've been making in the business, coupled with a disciplined approach to balanced revenue growth with improved profitability.

We continue to execute on our capital deployment strategy to maintain a strong balance sheet, return capital to shareholders, and create growth and scalability.

With that, I would like to open up the line for your questions.

Question-and-Answer Session


[Operator Instructions] We'll take our first question from Tom Roderick with Stifel. Your line is open. Mr. Roderick, your line is open. Mr. Tom Roderick?

Tom Roderick

Sorry about that. I was on mute. Thanks, guys. Good morning. Mike, wanted to start the first question for you here talking about Smart Tuition. It is a nice asset that, you know, it kind of looks like it fits well with the WhippleHill side of the equation, builds you up in K-12 a little bit. Can you talk a little bit more here about what you've done to integrate that asset, both organizationally and technically?

And as you get through Smart Tuition, I'm curious as to the appetite and interest level in perhaps looking at other M&A opportunities and where those opportunities might lie for you later in the year?

Anthony Boor

Tom, this is Tony. I wanted to make one real quick correction if I could. In my prepared remarks I misspoke regarding organic subscription revenue growth. Our organic subscription revenue growth actually came in at 18.9% and I think in my prepared comments I had stated 18.6%. So wanted to make sure we got that corrected. Mike, if you want to jump in.

Michael Gianoni

Okay. Hey, Tom. So couple things, Smart Tuition first. We have integrated kind of the front end on the application side and we've deployed a single sign-on, so customers can get at that solution through the WhippleHill on products as well, so that's complete and behind us, and that really helps from a go-to-market and integration standpoint.

As you recall, there was little overlap between the Smart Tuition and our existing K-12 customers. So we are aggressively cross-selling into that base both, kind of both ways, which is going quite well.

We also have begun to integrate the back office much more aggressively, as we have done with the other acquisitions, and that's going well. So it's proved out to be what we thought large, very under penetrated market, and we like the upside and it’s gone quite well.

Organizationally, we're pretty complete with what we're going to do there as well. So we're achieving the synergies in our internal case, if you will. And so we're happy with the progress six, seven months post closing. That's going well.

Now more M&A in the space; I think that what we've been doing the last two years has been proving to be a healthy strategy for us. K-12 is a good example where the acquired businesses, post integrating the applications, have made our traditional portfolio, like Raiser's Edge NXT and Financial Edge NXT and payments and analytics, a stronger offering because they are integrated with the business side of running the schools.

And in turn, it’s made those acquired applications and acquired companies a stronger offering, given the integration with our fundraising capabilities. They are becoming unique in the space in K-12, where our historic competitors don't have sort of the business outside and the business app companies we purchase don't have the fundraising side.

And so it’s a significant value prop for the prospective customers to have fully-integrated solutions. And in most cases, we're replacing four, five, six small-point solution vendors with a single integrated platform.

So that type of execution and M&A opportunity we see as favorable and we see more opportunities. We study the opportunities by sub-vertical and so I think there is more to do there in the space. It strengthens our core company and broadens our TAM and makes us a heck more competitive in those sub-verticals.

Tom Roderick

Great, thank you. And Tony, let me throw my follow-up question at you here just in thinking about the cadence of both revenue growth and your cash flows throughout the year.

You guys don't guide quarterly, but given that you do have some quarterly fluctuation on a seasonal basis due to payments and that's going to be exacerbated this year by Smart. Can you just give us a sense as to how that cadence might play out, whether it's linear, whether we should see a spike in Q2 due to payments?

And then on the cash flow side, the cash flows, as you noted, were a bit lower than historical for Q1. So kind of curious what gives you the confidence to maintain the guidance on the cash flow front? Thanks.

Anthony Boor

Thanks, Tom. So on the revenue front, from a seasonality perspective, we will have to keep an eye on that. We obviously haven't guided to any quarterly numbers or specific changes in seasonality. I don't expect a material difference in our overall seasonality as a result of the addition of Smart.

I think you hit it on the head there, Tom. As we see incremental penetration of online and payments, that may drive some difference in seasonality on revenue for us. I wish I could predict exactly where that's going to be. But that's something we will just have to just let play out and see how the market shifts more and more to online and electronic payments.

From a cash flow perspective, operating and free cash flow I'll speak to, in the quarter we continue to grow as a company and the hit we took in Q1 comparatively to the prior year really equated to incremental accrued bonuses that we had on the balance sheet at the end of last year.

And so that was right in line with our expectations; hence, we didn't change our full year guidance. We're sticking with our 2016 guide for operating cash flow of $145 million to $155 million. And then our aggregate aspirational goal that we took up, as you know, recently of the $500 million to $550 million over the four year period ending in 2017.

We don't guide to free cash flow. We have not historically, but I will tell you that we feel good about the expectations for free cash flow as well. And we would expect to see a positive increase year-over-year on free cash flow also, even though we haven't guided to it specifically.


We'll take our next question from Steve Ashley, Robert W. Baird. Your line is open.

Steve Ashley

Great, thanks. Can you hear me?

Michael Gianoni

Yes. Go ahead, Steve. How are you?

Steve Ashley

Sorry. Just like to ask about Raiser's Edge, RE NXT. Just wondering if you could talk in general terms about the kind of growth and demand you are seeing and the kind of mix generally, new versus existing customers.

Michael Gianoni

Steve, its Michael. I'll take that. The growth continues at a pretty healthy clip in all of the sub-verticals with both existing customers moving and net new customers.

But the interesting part about that is given the architecture and the integration and the sort of intuitive nature of that platform, it is making it much easier for net new customers to see a much higher ROI and value prop compared to previous version, if you will, because it's mobile first, kind of one design, device agnostic, and very intuitive with dashboards. In a lot of cases it eliminates the need to run reports, because the information is just served up to the user.

Given the modern interface and workflow, it's much more adoptable for net new customers and so we've seen a nice ability to sort of drive that to net new, and existing Raiser's Edge 7 customers sometimes are pretty shocked about what's happened here. They didn't really - they sort of expected kind of the usual version upgrade.

Once they really get into a demo and really seeing the product and understanding it's so much more than Raiser's Edge and how the system works and the fact that it's role-based, there's a lot of excitement in the existing customer base as well. So we're excited about how that program is moving along.

Steve Ashley

Then I would just like to ask a question on payments. Are you actively cross-selling that into the installed base of Raiser's Edge? And what kind of adoption have you seen from that?

Michael Gianoni

We sure are. We started that, I don't know, 18 months ago or so, Steve, and that doesn't end. So we cross-sell that into existing eTapestry, existing Luminate, existing Raiser's Edge customer base.

The up-tick is very healthy. The value prop is very straightforward and what I mean by that is that, if the customer is using a different payment engine, the cost to them is neutral to switch, but the operating improvements are significant, given our integration. So we cross-sell that into all of the platforms, not just Raiser's Edge, and so the value prop is quite straightforward.

And as you know, in our newer solutions, like Raiser's Edge NXT or for net new customers that we're selling Raiser's Edge NXT or Luminate to, we just bundle that in now, which we haven't done in the past. And so it's just becoming a part of all of our platforms over time.


And we'll take our next question from Brad Sills. Your line is open.

Unidentified Analyst

Hey, guys. Thanks for taking my question. I just had a question on your announcement here on re-orging the sales-force from hunters to - both hunters and then also account managers. Why now, I guess is my question, and what has been the response so far?

Michael Gianoni

Yes, I wouldn't think of it as reorganizing the sales-force. I would more think of it as adding incrementally a customer success function, which we have had, we're just growing the headcount in customer success. Let me explain why we are doing that.

Given the fact that most of our revenue now is cloud, in a cloud software company you need to have a customer success function or an account management function. And it's really about helping our cloud customers become successful with our solutions. In the long run it's about expanding our presence with the base and retaining customers around contract renewal time.

The intended consequence of that is it frees up our sales executives to just focus on selling, either cross-selling into the base or net new, and spending much less of their time managing existing relationships because that moves over to a customer success.

So it's really not restructuring; it's growing the customer success function, which adds productivity opportunities for quota-carrying account executives.

Unidentified Analyst

Got it, great. Then my follow-up is just on some of the migrations you are seeing from maintenance to subscription. As customers migrate to Financial Edge and Raiser's Edge NXT, are you seeing the pricing uplift that I think you had mentioned in the past on the subscription like-for-like customers?

Michael Gianoni

We are seeing the uplift that we intended and we are also seeing opportunities to bundle in things like payments, which is not really calculated in the base of uplift, if you will, because it's an add-on. And because of the integration that we've done with things like payments it's providing kind of an uplift incrementally for that platform as well.

But, yes, we are pleased with the uplift from a maintenance payer, if you will, to cloud. What's really important, too, for our customers is the value prop is significant. The ROI for them is much better as well. So it's a win-win.


[Operator Instructions] We'll move next to John Rizzuto. Your line is open.

Unidentified Analyst

I want to draw on the payments a little bit more as you talk about that. As you look at that payment component, is there a way or do you have a way to characterize in your installed base what - how much of that right now they are doing away from you or is out there that you really think you could capture?

Michael Gianoni

If you recall in our IR presentation materials from investor day last fall, we talk about the TAM for that slice of the pie on that one page there, John, in our penetration, which is very small today. Most of the industry is actually cash and check, believe it or not, so that's one really important data point.

The other important data point is most of the industry is not online and that conversion is happening faster and faster, where you have kind of a mid-teens growth of the online and you have a 3%, 4%-ish growth of the whole payments, referring to the macro of US donations.

I think the opportunity is big. As we continue to drive innovation and continue to move customers to our cloud, like NXT or the aggressive cross-sell we have just in the existing base like RE and eTap and Luminate, it's a growing opportunity for us. And so it's a healthy platform for us and the value prop is really straightforward.

It's really interesting. I spend a lot of time with customers and when they get to understand the integration and the fact that their costs are pretty much neutral if they are using an existing provider both the value prop and automating the back office, which is what integration does for them - for us, it's quite straightforward.

Unidentified Analyst

Okay. And then again about vertical solutions, just a follow-up here. The vertical solutions you talked about going after sub-verticals, as well within market.

Are there any in particular at this stage that you would call out or ones that you think really for Blackbaud represent an untapped potential? Whether it's in a vertical maturity in like a higher education or education, faith-based giving, or what it might be. Just particular areas that you think are attractive for Blackbaud to be thinking about.

Michael Gianoni

There's several that are, John. I won't actually name three or four because it's not the right thing to do.

And they are all very different, too. If you think about what we have done in K-12, we've kind of doubled down a bit and we've gone really wide, and so we are providing solutions that cover most of what a school needs: running the school, tuition management, and fundraising.

But then if you look at things like hospitals or higher ed, odds are we're not going to cover that whole vertical in the full way that we can with K-12. I mean the higher-ed guys are putting in Workday for HR and Concur for T&E.

They are so big; we can't cover that school like we can at K-12. But there are many, many like K-12 that we can have broad coverage in and really change the competitive dynamic for us by going wider into the business side.

And so there are many of those. Yet in the very larger ones, like higher ed or hospitals, for example, there are more that we can do to expand near-adjacency TAM, just not across the entire enterprise like some of the others.

They're a little bit different in their makeup and how we think about them, but we feel there's a lot of M&A opportunity out there for us again to do, like we've done in K-12.


[Operator Instructions] We'll move next to Ryan MacDonald. Your line is open.

Unidentified Analyst

Good morning. Starting with Mike, just quickly just - and Tony as well, digging into the additional hiring that you are looking to do. Outside of customer success, what segments within the sales organization are you looking to make additional hires throughout the year? Then are there any additional associated costs with the current sales initiatives that you have in place?

Michael Gianoni

Sure, couple things. We are growing our customer success headcount, to my earlier point, and we are hiring quota-carrying sales executives, account executives in actually many areas. Many of our sub-verticals we're adding to folks, so the folks that are kind of dedicated in verticals.

We are also hiring folks that have more geographic territory to go a little deeper in some of the key geographies. It's fairly widespread in where we are adding to quota-carrying account executives.

Related to the sales effectiveness and sales operations initiatives, no, it's not a big cost for us to do that. The upside is productivity and the upside is driving a common back office across global sales, a better way that we have had in the past. But the goal is being able to scale up faster with better operational support as we bring on new account executives and to get more productivity per rep.

Anthony Boor

I think, Ryan, a lot of the investments we've been making in the back office systems over the past couple years really are what will help us drive some of this efficiency and effectiveness across the org.

So having a single CRM platform that now we're optimizing will help drive a lot of the efficiencies and effectiveness on the sales effort; same with customer success. So it's really utilizing those back-office investments we made over the last couple of years.

Unidentified Analyst

Got you. Then just a quick follow-up. You mentioned in your prepared remarks that you had over 7,000 customers now using Blackbaud SKY and SKY UX. Is that all Raiser's Edge and Financial Edge NXT, or is that also including now the entire six platforms that are being supported by SKY UX?

Michael Gianoni

Thanks for that question. The SKY announcement, I think I said this when we first started talking about SKY last fall, I believe is one of the most, if not the most, significant announcement we have made, because it talks to the modern engineering capabilities of the company that is a set of tools and capabilities that is companywide and product and a platform agnostic.

The recent press release and the over 7,000 customers, that is across six applications, and Raiser's Edge NXT and Financial Edge NXT are only two of the six. And so we talked about that in the press release just to show the progress on the modernization of the entire portfolio and the speed of which we are executing that.

The next big one you will see is the Luminate next-gen initiative that is underway right now, which will be just sort of number seven. And so soon enough many of our most broadly-used solutions will be in the SKY UX and then later this year SKY API set of capabilities. So we're making great progress quite quickly.


We'll take our next question from Kevin Liu of B. Riley & Company. Your line is open.

Kevin Liu

Hi. Good morning. First question, just as a follow-on to the discussion of NXT migrations. What is the attach rate you are seeing for those customers that didn't have payments previously? And then maybe in the context of your payments growth, to what extent is that driven by the uptake from migrations versus just higher volumes of payments from the clients that have signed on?

Michael Gianoni

Kevin, attach rates are really high, but the other thing is happening is we are having great success in the cross-sell I just talked about a couple minutes ago as well. And so the payments attach rates, cross-selling into the Luminate base, the existing Raiser's Edge and eTap base and with NXT have pretty high attach rates that we are quite pleased with.

So that's going quite well. Again, integration is the key there.

I'm sorry, what was the second part of your question?

Kevin Liu

Second part of that was just whether you're seeing pretty strong volume up-ticks with those clients that had already signed on, or if the growth in payments is predominantly driven by just new customers signing on the platform.

Michael Gianoni

It's both, actually. You think about our business, the payments is sort of volume and event driven. If a customer, for example, went live today, let's say on our payments platform, we might have missed their Q1 events, but next year we will pick them up. And so we get a nice up-tick in volume and payments, transaction revenue when customers go live.

But then when we get the full circle of a full calendar year, we start to pick up all of their events and all of their activities, then we get organic growth in future years off of that as well.

So it's a combination of signing up cross-sold customers, including payments with net new customers on our platforms, and then getting the 12-month opportunity to get all of their events and the organic growth from those events is the cumulative part of that.

I also want to add too, and we had payments questions on this call. Again, I say this a lot: Blackbaud is not just a payment story either. We are seeing really solid growth across the portfolio and it's important to know that with all of our cloud solutions.

Kevin Liu

Got it. One quick one for Tony, if I could. Just in the context of being on track for your fiscal 2017 expectations on the margin side, does that contemplate keeping capitalized software relatively flat year on year? Or how are you thinking about how that impacts your ability to achieve those targets?

Anthony Boor

That's a good question. Cap software is an interesting one to predict of where that will come out, because as you know, we talked about this before. The cap software is really a result of us executing against our strategic initiatives.

When we talked about it a couple years ago at our first investor day after Michael came on board, we talked about the fact that we are going to optimize our portfolio. And so we are reducing the total number of products, for instance, in the online space and elsewhere, so we were consolidating to fewer products.

We brought on a whole new quality team and initiative and so we're improving the quality of our code, which means we can spend less time on bugs and more time on innovation, and then we are also significantly ramping up our engineering spend.

As a result, we are spending much more money per product on innovation today than what we were historically, which we believe is helping to drive these integrated suites and, therefore, drive the nice acceleration in growth that we are seeing.

The result of all of that, because a much higher amount of spend on innovation requires under US GAAP that we capitalize those amounts and amortize them, so it's really the effect of all that strategic initiatives that's driving the increase in cap software. We went from about $8 million in 2014 to $15 million in 2015 and we expect that to ramp fairly significantly again this year.

As far as 2017 goes, we haven't given any guidance there. I would expect just what we know today; that it would be at least as high as what we have in 2016 because of the continued investment in innovation and the positive improvements in quality that I think we will continue to see some benefits of next year. So I do expect we will see some rather stable or higher cap software amounts this year and going into next. I do think that will flatten out over time.

Then one of the things, Kevin, I wanted to make sure everybody understood; I've got this question a couple of times. Is that cap software driving some of our margin improvement?

I would tell you, when you look at the cap software in conjunction with the total R&D spend, the total engineering spend, which is up substantially over the last couple of years from 2014 to 2015 and then again 2015 to 2016.

And then you also couple in the expanded spend we've had on our infrastructure and preparing for the move to the cloud on the mid-market, we spent quite a bit more in the RDO area and infrastructure.

If you aggregate our depreciation and amortization of the software, the increased engineering spend, the increased RDO spend, and put that all together it was actually about a 40 basis point drag on margins last year in 2015. So it actually pulled us backwards a bit.

Depending on where those numbers come out in 2016 I expect we could have a slight improvement to overall margin structure. But, again, that will depend on what all of those costs we incur qualify for capitalization.


We'll take our next from Mark Schappel. Your line is open.

Unidentified Analyst.

Hi. Good morning, thank you for taking my call or – excuse me, my question. Michael, a question for you. One of your sales strategies has been introducing VARs into the selling mix. I was wondering if you could talk about whether the VAR channel contributed during the quarter and maybe just give us an update on some progress you've made on that front during the quarter.

Michael Gianoni

Sure. We've had VARs in the business in the past and, frankly, hadn't done a great job in managing and driving that appropriately. So it was a win-win for us in VARs. We've changed the structure of that a bit so it is a win-win.

We are signing up new VARs at a pretty decent clip. It's not going to be a massive shift for us, but its additive. And I would say not a big contributor to Q1 because it's a fairly new ramp-up, but we think it will be interesting in future periods, if you will, as these VARs come up to speed in a different, more collaborative way that we've done this in the past.

So it's early days on that new channel.

Unidentified Analyst.

Great, thank you. Tony, with respect to the online payments business, is it fair to assume that growth of the payments business in the quarter was relatively consistent with subscription growth?

Anthony Boor

I think the only place, Mark, I would say we have a little bit of nuance there would be, in generality, the addition of Smart Tuition would cause a bit of abnormality there. So Smart has a bit higher mix of payments just by the nature of their business than what we had with our legacy business. So you'd have to account for the fact that we just purchased Smart fourth quarter of last year, so that would have had a bit of a downward pressure on gross margins.

That said, Smart, inclusive of our obtained synergies to date, is very accretive to operating margins.

Unidentified Analyst.

All right, thank you.


We'll take our next question from Ben McFadden, Pacific Crest. Your line is open.

Ben McFadden

Hey, guys. Thanks for taking my questions. Mike, I just want to start with, we've talked multiple times on this call kind of about that uplift that you're getting when a customer goes from maintenance to subscription. I wonder if you could provide just any color of kind of what that uplift looks like across the installed base.

We've also talked a lot about the payments business, but just any color on kind of what portion of the installed base is using analytics would be great.

Michael Gianoni

Sure. For uplift, it varies by customer and it varies by sort of the good/better/best package they choose. And then it varies on what they want integrated or bundled with that. I'll give you some examples.

If you are an existing smaller Raiser's Edge customer that is paying maintenance, your pricing is dependent upon the size of the database that you have as a start. Then it gets a bit complicated pricing uplift-wise, if you will, if you choose - whether you choose the entry-level, mid-, or higher-level offering in the Raiser's Edge NXT family. There's a good/better/best, but it also has a second factor on that pricing model.

And then some of the mid-tier to higher Raiser's Edge customers would also opt to go to Raiser's Edge NXT and go with Luminate online, because they have a larger digital marketing set of efforts and footprint, which is an additional pricing bundle. And then another factor is if you're using our payments engine, which drives transaction revenue.

We don't have - don't breakout a number for that. It's all over the map, but I can tell you that if you are a maintenance-paying customer going for the smallest tier or first-tier Raiser's Edge NXT, there's a healthy uplift in revenue for us. And there's an opportunity for organic growth, given it's a SaaS pricing model and not a maintenance pricing model. If that all makes sense.

Secondly, for analytics, we don't have a high penetration of analytics into the existing base, but the products are bundled with all of our new solutions. And not just NXT. We announced, for example, an analytics product bundle in Luminate CRM recently.

We continue to bundle more and more analytics in our lower end eTapestry and we also have done more and more in our enterprise CRM platform as well. Not a high penetration rate, but a very significant value prop for our customers. And so it's very much - our analytics products are very much a differentiating solution for us.

What's key to know is we provide very specific, purposely-built analytics solutions, and it's not just a toolkit for customers to use, but they are out-of-the-box productive because they are built to do a specific job for our customers.

And so the value prop is quite straightforward for the customer. We're forcing a lot of success in customers driving more revenue for themselves with these solutions or reducing back-office operating costs with these analytics solutions as well.

We have several solutions and some of them are vertical. Some of them are for hospitals; some of them are for other verticals as well. So it has been a really great value-add for us and its early days on driving that across the base like it is for payments.

Ben McFadden

Sure, great. And then, Tony, just a question on the license. It looks like it came in lower than what we've seen in the past. Obviously, that's just the enterprise CRM product now.

But just I wonder if you could talk kind of is that just Q1 seasonality? Is the enterprise CRM product still growing? And are you seeing some of those potential enterprise CRM customers look at NXT instead?

Anthony Boor

That would be I think - two places we still have license largely will be CRM-driven. We do still sell a handful of new modules or user licenses back to the existing base of on-prem customers, so that volume has shrunk substantially from where it had been even a year ago. And that is because that base is migrating, as you know, to the NXT product set largely.

On the CRM, it's the same story we've had since I've been here. It's really just a very lumpy business. Those are big enterprise deals. They're long sales cycles, long implementation cycles; in many cases would be multimillion dollar deals.

And so I wouldn't put anything to any significant change there in the market. It's just the lumpy nature of the software business on the enterprise end of things. Today it's such a small percentage of our total revenue that it's really not impactful as it used to be a couple years ago.

Ben McFadden


Michael Gianoni

The only thing I would add on the NXT side to that question, Ben, is I believe we have more customers that are the larger RE customers who had not moved to enterprise CRM, given the complexity and the cost, and the fact that they are happy with RE are starting to move to NXT.

So it's more over on the side of they have a really solid platform to go to and not opting out of going enterprise CRM, because they weren't going to go there anyway. So it just gives us more opportunity with the larger RE customers. Seen that in a couple cases.


We'll take our next question from Justin Furby. Your line is open.

Unidentified Analyst

Hi. Thanks and congrats on the quarter. And I joined late, so apologize if this was covered, but if you look at the maintenance revenue, it looks like the deceleration picked up sequentially and so the assumption is that the NXT migration is, in turn, accelerating.

I just wanted to make sure that's the right conclusion and try to understand what's driving that. Is it more customers coming to you and saying, hey, let's move or are they being incented to do that?

Then how do you feel about from a services, from a professional services capacity, the ability to meet the demand of your customer migration? So lots of questions in one, sorry, but thank you.

Michael Gianoni

Sure, Justin, this is Michael. Yes, the maintenance line went down that is a planned event and that will just sort of continue over time. It's a mix of RE NXT and Financial Edge NXT in its mix.

We also have within our Gifts Online product we have maintenance payers, if you will, with that MicroEdge acquisition we made 18 months ago or so. We're pretty far into moving those maintenance payers to Gifts Online as well, so that's a part of that transition.

In general, you could think of it as the shift to the cloud. It's planned and that will continue.

We have a mix of customers coming to us, your other question, on moving to NXT or RE NXT or Gifts Online and us going to them. We started in the beginning of 2015 this kind of roadshow the goes to major cities.

We bring in a couple hundred customers, either existing or net new, and this has mostly been built around Raiser's Edge and Financial Edge NXT. So they get to see and experience and hear from third-party experts on this new platform, which is kind of driving the base to move as well. We believe it's all a healthy move for us.

As far as services, I think we're in good shape there. At the top of the P&L you will continue to see maintenance and services, as a percentage of total revenue, go down over time, but we think our services revenue line is doing fine. We're improving the margin that business. We have hired some different executives over the last 18 months to kind of drive that.

We think we're all set from an ability and capacity to drive migrations and implementations, both at the small and mid-tier, like eTap and NXT, and with the large enterprise guys. We think we're in pretty good shape there, driving that business to make sure our customers are successful.

Anthony Boor

Justin, just a couple things I would add from a high level of what you expect for the curve on maintenance. Like most migration, we'd expect to have a bit of a bell curve approach to that, so we're in the early stages incentivizing.

We think that the product and the word-of-mouth will start pulling more customers with it over time, so we'd expect to see a much larger ramp over the next couple of years. And then we will get that back side of the curve where we have to start moving those final last customers over.

On the services, the other thing I would add to Michael's is we've done a tremendous amount of work on the engineering front with the services team to automate and to build tools and to really streamline that migration process. In many cases, we've talked about before, and I'm not sure if we spoke to you about it, so I want to mention it.

We've gotten to the point where, in many cases, for folks who don't have a lot of customization it is an over-the-weekend kind of migration from their existing product to the new product. And so that's a big added benefit. Therefore, we don't have to have a big services team a lot of those engagements to actually migrate them to the new NXT product set.


And there are no further questions at this time. I'd be happy to return the call to Mr. Michael Gianoni for any closing remarks.

Michael Gianoni

Great. Thanks, operator. Thanks, everyone, for the good questions. I'll just close by saying Q1 was a solid start to the year for us. We look forward to reporting our progress against our financial guidance for the year and long-term aspirational goals on our next call. So thanks for your participation.


Thank you. This does conclude today's Blackbaud 2016 first quarter earnings conference call. You may now all disconnect your lines. And everyone, have a great day.

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