SPS Commerce's (SPSC) CEO Archie Black on Q2 2016 Results - Earnings Call Transcript

| About: SPS Commerce, (SPSC)

SPS Commerce, Inc. (NASDAQ:SPSC)

Q2 2016 Earnings Conference Call

July 27, 2016, 16:30 ET

Executives

Lisa Laukkanen - The Blueshirt Group, IR

Archie Black - President & CEO

Kim Nelson - EVP & CFO

Analysts

Tom Roderick - Stifel Nicolaus

Scott Berg - Needham & Company

David Hynes - Canaccord Genuity

Matt Pfau - William Blair

Matthew Carletti - JMP Securities

Jeff Houston - Northland Securities

Operator

Welcome to the SPS Commerce Second Quarter 2016 Earnings Conference Call. [Operator Instructions]. I would now like to turn the conference over to our host for today's call, Ms. Lisa Laukkanen. You may begin.

Lisa Laukkanen

Good afternoon, everyone and thank you for joining us on SPS Commerce's second quarter 2016 conference call. We will make certain statements today, including with respect to our expected financial results, go-to-market strategy and efforts designed to increase our traction and penetration with retailers and other customers. These statements are forward-looking and involve a number of risks and uncertainties that could cause actual results to differ materially. We note that these forward-looking statements reflect our opinions only as of the date of this call and we undertake no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

Please refer to our SEC filings as well as our financial results press release for a more detailed description of the risk factors that may affect our results. These documents are available at our website, SPSCommerce.com and at the SEC's website, SEC.gov. In addition, we're providing a historical data sheet for easy reference on our Investor Relations section of our website, SPSCommerce.com. During our call today, we will discuss adjusted EBITDA financial measures and non-GAAP earnings per share. In our press release and our filings with the SEC, each of which is posted on our website, you will find additional disclosures regarding these non-GAAP and adjusted EBITDA measures, including reconciliations of these measures with comparable GAAP measures.

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

Archie Black

Thanks, Lisa and welcome, everyone. We had a great second quarter. Total revenue grew 22%, to $47.4 million. Recurring revenue grew 23% and adjusted EBITDA was $5.7 million. Our success continues to be driven by the adoption of omnichannel commerce. Consumers have come to expect seamless shopping experiences and fast, flawless fulfillment across multiple channels. Legacy technology and solutions that support single-channel shopping are no longer sufficient in an omnichannel world.

This evolution is providing a tailwind to our growth. Now more than ever before effective trading partner relationships between retailers and suppliers rely on collaboration to efficiently optimize performance and consumer engagement.

Whether it is the online or in-store experience, retail is rapidly changing due to the demands of the consumer. It is imperative that both retailers and suppliers have the ability to quickly adapt to the omnichannel trends in order to remain competitive. Our solutions enable suppliers and retailers to address these changes quickly and efficiently and help them grow their businesses, improve their profitability and remain ahead of the competitive curve.

For example, at one point Fruit of the Loom was utilizing five different EDI platforms across its businesses and it took up to six months to get a new trading partner up and running which was resulting in lost opportunities in the marketplace. They replaced their five platforms with SPS to become more agile, efficient, consistent and automated with their EDI transactions and reduced their trading partner onboarding timeline by over 75%.

Retailers are also feeling increased pressure to stay competitive in the marketplace and we're seeing the effects of this through expanding interest in fulfillment enablement campaigns. SPS is in a unique position to work as a strategic advisor to both retailers and suppliers to help address the changing retail landscape. One example is a community enablement campaign we conducted with HEB Grocery Stores. Recently HEB made significant investments to improve its supply chain and to create a world-class distribution model. As a result, HEB saw the benefits to streamlining current processes and made electronic fulfillment a requirement for all vendors.

They then turned to SPS for our expertise and in partnership we ran a community enablement campaign to help them onboard their vendor community. Our fulfillment product gives HEB increased visibility into their supply chain and allows them to better evaluate their vendors. HEB is now able to seamlessly communicate and collaborate with suppliers on orders, resulting in faster fill rates and fewer stockouts. Community enablement campaigns such as this demonstrate the increasing requirements from retailers to have an agile supply chain and are also an important lead generation source for SPS commerce.

Collaboration between suppliers and retailers further enables trading partners to address consumer needs. Our analytics solutions help to improve margins and sell-through and drives growth and efficiency for both retailers and suppliers. Rawlings which is best known for its high-quality baseball equipment, has used SPS Commerce fulfillment for some time and a year ago started using analytics. They looked at store-level inventory details to determine which stores were selling baseball equipment at what times and determined that in certain areas they could start selling earlier in the season which resulted in an additional month of sales, improving both their profitability and the retailers'. Additionally, they sent the sell-through data to their product development team to optimize their products for future seasons.

The digital revolution is here. At In:fluence, our annual customer event, we welcomed hundreds of retail executives to explore how retail will change more in the next five years than it has in the past 50. The retailers and suppliers who are gaining market share today are doing it by building stronger, more meaningful consumer connections. Today the only way to meet the demands of the consumer and build their loyalty is through a more agile supply chain.

Our opportunity is more robust than ever and we continue to execute. The increasing need for collaboration between trading partners continues to be fueled by the omnichannel shopping experience that consumers have come to expect. SPS sits at the forefront of this trend and this provides a tailwind to our success. I look forward to extending our market leadership in the second half of 2016 and beyond.

With that, I'll turn it over to Kim to discuss our financial results.

Kim Nelson

Thanks, Archie. We had a great second quarter. Revenue for the quarter was $47.4 million, a 22% increase over Q2 of last year and represented our 62nd consecutive quarter of revenue growth. Recurring revenue this quarter grew 23% year over year and 18% organically. The total number of recurring revenue customers increased 6% year over year, to approximately 24,200.

For Q2, wallet share increased 16% year over year, to approximately $7,200. For the quarter, adjusted EBITDA was $5.7 million, compared to $5 million in Q2 of last year. We ended the quarter with total cash and marketable securities of approximately $136 million. We ended the quarter with approximately 270 quota-carrying sales headcount which puts the company back to historical annual hiring levels. We will continue to add sales headcount to offset normal attrition levels, but the majority of the 2016 planned hires have already occurred. As a reminder, there's a 9- to 12- month initial ramp and we feel confident in our ability to be back at 20% organic recurring revenue growth levels in the second half of 2017.

Now turning to guidance, for the third quarter of 2016 we expect revenue to be in the range of $48.7 million to $49.2 million. We expected adjusted EBITDA to be in the range of $6.4 million to $6.9 million. We expect fully diluted earnings per share to be approximately $0.05 to $0.06, with fully diluted weighted average shares outstanding of approximately 17.3 million shares. We expect non-GAAP diluted earnings per share to be approximately $0.24 to $0.25, with stock-based compensation expense of approximately $2.1 million, depreciation expense of approximately $1.8 million and amortization expense of approximately $1.2 million.

For the full year, we expect revenue to be in the range of $192.6 million to $193.6 million. We expect adjusted EBITDA to be in the range of $25.7 million to $26.5 million. We expect fully diluted earnings per share to be in the range of $0.21 to $0.23 and we expect fully diluted weighted average shares outstanding of approximately 17.2 million shares. We expect non-GAAP diluted earnings per share to be in the range of $0.96 to $0.98, with stock-based compensation expense of approximately $8.3 million. We expect depreciation expense of approximately $7 million and we expect amortization expense for the year to be approximately $4.8 million.

For the year you should model approximately 40% effective tax rate, calculated on GAAP pretax net earnings. We expect to pay nominal cash taxes in 2016 due to our NOLs.

In summary, we had a strong second quarter. Looking to the rest of the year, our new business pipeline remains robust as the retail industry increasingly adopts omnichannel strategies. We look forward to expanding our market leadership and we're confident in our ability to achieve our long term targets.

With that, I'd like to open the call to questions.

Question-and-Answer Session

Operator

[Operator Instructions]. And our first question comes from Tom Roderick, Stifel. Your line is open, Tom.

Tom Roderick

Archie, let me throw the big picture question at you here, just given that we've seen over the last 90 days a number of sort of major retailers out there in the U.S. here kind of put up some disappointing results and it really does seem as though the ecommerce, the broader omnichannel theme, is even catching some larger traditional retailers by surprise.

So I would love to hear not only what your supplier customers are saying but your retail partners. How do you see them reacting to these changes? Are they starting to react more aggressively in the wake of more disappointing results recently? And how does that influence their decisions to force enablement campaigns, to push through analytics and data to their partners on the supplier side? What do you see changing on the retailer side of the engine here?

Archie Black

Well, I think what we're seeing is it's very obvious that if you don't have a clear omnichannel strategy as a retailer you're not going to win. And one of the challenges somebody like Sports Authority had is they did not have an omnichannel strategy. They had an ecommerce strategy and they had an in-store strategy and the two divisions were run very, very separately. So we're seeing that people are realizing that they need to do that. And that is a tailwind for us that's forcing retailers to get more aggressive.

As we migrated from 2010 there was this excitement about ecommerce and it was an opportunity, but it really wasn't a threat. And it's in the bull's eye of a threat for retailers. They're either going to adjust or they're going to be gone. So we're seeing that that is a tailwind and I think they're going to get more aggressive just getting the basics as far as being able to dropship and the basics on the fulfillment side of equation.

From the supplier standpoint I think we're seeing more and more suppliers realizing that they need to be able to support their retailers and they're going to need to be able to dropship, meaning send product directly to the consumer, because that is the way retailers are going to expand their item counts is at least by trialing it on the website. So obviously to those that don't survive it's not a positive, but those that do survive I think it ends up being a tailwind for us.

Tom Roderick

Kim, question for you, you guys have been getting questions all since last winter regarding the state of your sales force. Looks to me like you hired 22 new heads this quarter. You're up 22 net, 32 net for the year. I know the goal is 25 to 35 coming into the year. Does the pace where you're at sort of exiting Q2 change the way you think about the upper end of what you wanted to hire this year or do you just kind of get there sooner and put the cap on it earlier in the year?

And then with respect to how you're getting there, I'd love to hear about what strategies and tactics you've put in place that are putting a better capacity in place and keeping it there.

Kim Nelson

Sure. So as it relates to the sales capacity, we were able to get to our historical average hiring, that sort of net 25 to 35, we were able to get there at the end of this quarter, so that's a positive. What we experienced was, as you know, we do a lot of college hiring and they can start in June, right when they finish school or they could start later in the summer and really that group has come in here and the majority of those actually started in the month of June.

So that is reflected within our quota-carrying headcount. So way to think about it is we're basically where we had wanted to be for the year and we'll continue to hire throughout the year, but the focus there on hiring is more to offset normal attrition levels, not to increase the total number of heads versus what our expectations were. The positive as it relates to that, then, is the ramping, as it relates to our sales force.

Usually it's about a 9 to 12 months when somebody initially joins the Company to when they're in their what I would call sort of their first initial ramping. And so the positive of being where we wanted to be for the year at the end of Q2, that then translates to the Company being in a position to be back to an organic recurring revenue growth rate of 20% in the second half of 2017, because, again, we ended up being able to do that hiring and you see it reflected on our hiring numbers as of June 30.

Tom Roderick

So as far as when we ought to be thinking about a full return to sort of 20% recurring organic, you'd target second half of 2017 here.

Kim Nelson

That's correct.

Operator

And our next question comes from Scott Berg of Needham. Your line is open, Scott.

Scott Berg

A couple of quick ones for me. First of all, Archie, a lot of the commentary that you guys have talked about, not just this quarter but the last several quarters, several years, is around the omnichannel thesis and how that's driving your business, but could you talk about how maybe customers are buying your products today, whether it's the core fulfillment product or the use of it for just fulfillment maybe versus omnichannel versus some of the analytics products that you have? I'm just trying to understand what customer preferences or how customer preferences might be changing right now relative to where they were 6 or 12 months ago and what you're seeing in your pipelines.

Archie Black

I would say, Scott, that it continues to be an evolution, that each retailer is in a little different spot. Some of them are quite far behind and were able to get by without a strong foundation in fulfillment two, three, four years ago and as volumes increased with dropship you need new rulebooks, you need new way of doing business. So I think it depends where they are on evolution, but to the earlier point I think there's more and more fear that they need to jump onboard.

Unfortunately, some of the suppliers or retailers, are jumping onboard at very, very foundational levels that you would've thought they would've had done 10 years ago. But they've got to be able to walk before they run. So we're seeing it in all parts. It's what we're really seeing is a drive towards fulfillment has been a driver and in the quarter over -- what we're seeing is much more foundational work on fulfillment and less on the analytics. Obviously we think the long term opportunities continue to be there, but there was more activity on the fulfillment side than the analytic side.

Scott Berg

And I guess a follow-up for me, Kim, your gross margins were lower in the quarter than we had modeled. And knowing that they were going to be lower because of the ToolBox acquisition I just want to try to understand, is this what was reported in the quarter at roughly 67% on a non-GAAP basis, is that the way we should think about gross margins going through the end of the year or do some costs come out of that on the transaction that could -- that you tick them up as we start exiting the fourth quarter into early 2017?

Kim Nelson

Sure. You'll start to see some steady margin improvement in the second half of this year and then into next year. Really what you saw, experienced in Q2, if you think about our spend relative to revenue in the year, we had more spend in the front part of this year relative to the back half. When I say more spend I'm talking about relative to revenue.

So that put some pressure as it relates to the gross margin that you saw in the quarter. Really what we're doing is we're making sure that we're appropriately investing within the business and really want to make sure that we're delighting our customers. As you may recall, about a year ago we hired Beth Jacob to help run our overall customer success and customer experience and we're making sure that we make investments in that overall customer experience.

The way that translates into that expense relative to revenue and therefore into gross margins for this year, 2016, you see that that's put more pressure in this quarter on the gross margin and then we work into that in the back half of this year. So you would expect gross margins to begin to increase in the back half of this year relative to where they are now.

Operator

And our next question comes from David Hynes of Canaccord. Your line is open, David.

David Hynes

So, Archie or Kim, is it fair to think that the sales hiring blip we saw in 2015 is having a greater impact on your customer count numbers than wallet share growth? And then I guess as we think about your comments related to the return to 20% organic growth in the back half of 2017, is there an implicit assumption in there that customer count growth will reaccelerate?

Kim Nelson

So, the way you should think about the sales capacity issue that we saw in the back half of 2015, that has an impact in our overall organic recurring revenue growth and that's why you see that in the teens. In this quarter you see that as an 18%. So it wouldn't be correct to think about one component versus the other, meaning customer count or wallet share. It really has an impact on that overall recurring revenue growth.

As it relates to where we're now relative to sales capacity, we believe that we now are at a position that again by the second half of 2017 you're going to start to -- the Company will be back to sort of that organic recurring revenue growth rate of 20%. As far as the mix of what gets to the 20%, we expect we'll continue to have nice customer adds as well as wallet share, with the combination of the two translating to that overall organic growth rate.

David Hynes

Yes, okay. And then, Archie, maybe talk about what you're seeing in the CPG segment? I mean, you gave a nice example of the growth through enablement campaign, but curious if ToolBox has caused a bit of inflection in that segment. And then maybe you could segue that into kind of higher level thoughts on how that acquisition's performing in the seven months here that you've owned it.

Archie Black

Yes, obviously the ToolBox acquisition happened in January of this year. So far we've seen what we consider to be early stages very good progress on that front. We saw some uptick in revenue from supplier sales. No big retailer programs sold, but that wasn't expected, but nice pipelines there. And we feel like the overall integration is going really well. The example we used, one of the things is that, again, coming back, is that many of the CPG and especially in grocery and other segments, they are catching up. So they're really on the foundational front. So in the example of HEB it was really getting that strong fulfillment presence down and be able to really have your fulfillment in a position that you can build off of.

Operator

And our next question comes from Matt Pfau of William Blair. Your line is open, Matt.

Matt Pfau

First, Kim, just wanted to touch on the outperformance on the revenue line in the quarter and the full-year guidance for revenue which was maintained. So, was the outperformance primarily related to one-time enablement campaigns or something along those lines and thus that's the reason for maintaining the full-year guidance?

Kim Nelson

So, a couple of things as it relates to our results for the quarter. Where we exceeded or outperformed relative to the guidance was actually on ToolBox. So we saw nice, healthy growth there which was reflected in that overall growth rate. Specific within what I'll call the organic growth of the 18%, that total was in line with what we were expecting, but we actually saw some differences by product.

So we actually exceeded our expectations on the fulfillment and the growth associated with the fulfillment and we were light on analytics, that actually goes back to the comment that Archie was talking about as it relates to the community enablement campaigns, so one of the dynamics that we saw was that more of the retailers when they were working on various community enablement campaigns, more of that was focused on fulfillment community enablement campaigns, really, I think, in recognition of where many retailers are relative to where they need to be as it relates to their sort of ecommerce and overall omnichannel presence.

So specific within the quarter ToolBox beat and although we hit our own internal expectations organically we did see a mix shift between fulfillment and analytics in the quarter.

Matt Pfau

And then just wanted to touch quickly on the -- to get an update on any traction that you've seen international and whether it be Australia or anything in Europe.

Archie Black

Yes, obviously it's off a small base. We've had pretty reasonable success and we've highlighted over the last couple of earnings calls, in Australia. And, again, it's off a very small base, but have had tremendous success there. Europe is in line, I would call it in line expectations. I would consider Australia above line performance.

Operator

And our next question comes from Patrick Walravens of JMP Securities. Your line is open, Patrick.

Matthew Carletti

This is actually Matt on for Pat. I'm just curious, I know you talked about getting to that 20% organic recurring revenue growth rate in the second half of 2017. Do you see that as your target optimal long term organic growth rate, 20% or would you characterize it as 20% to 25% or higher? I mean, where would you go?

Kim Nelson

Sure. We look at, when we look at the opportunity we think it's a multibillion, conservatively at about a $4 billion TAM and then we believe we have the ability to grow organic recurring revenue at 20% on an annual basis for many years into the future. The caveat associated with that is obviously what we're dealing with right now which had to do with the sales capacity issues we experienced in the back half of 2015. Based on where we're at from a sales hiring, that issue in essence goes away in the second half of 2017. So I would characterize it as a 20% organic recurring revenue growth.

Operator

[Operator Instructions]. And our next question comes from Jeff Houston of Northland. Your line is open.

Jeff Houston

Starting with Archie, you mentioned a couple of big supplier manufacturers in your prepared comments, Fruit of the Loom and Rawlings. Could you talk a bit about your success in moving upstream to these bigger brands and is it more of an analytics or fulfillment or a little bit of both where you're seeing those bigger suppliers?

Archie Black

Yes, as you know, over the last five years we've really seen a migration of being able to land larger and larger supplier deals at SPS Commerce and I think like of Fruit of the Loom as an example of that. I think there's a number of things behind that. One, the pace of change in an omnichannel world for a large supplier is now beyond what they possibly can do on their own or they at least want to be able to do on their own, our position as the clear market leader as a company and then just the backdrop in corporate America of accepting cloud.

I was at a very, very large supplier and they showed their technology buying decision and what was interesting is one of their top three criteria was cloud first which is obviously fantastic for any cloud provider, but it is fulfillment and analytics. We've always had the large analytics suppliers. But where the change in traction is on the fulfillment side.

Jeff Houston

And then switching over to Kim, you mentioned some weakness in analytics and strength in fulfillment. And can you talk a bit about the relationship there? Is it one is successful at the expense of the other, kind of pushing and pulling or is it just kind of a one-time customers seemed a bit more interested in fulfillment this quarter?

Kim Nelson

Sure. It's related back to community enabling campaign, so when we worked with a retailer to help the retailer solve a business problem. And at the end of the day the retailers need to prioritize where they're spending their time. And so what we experienced in the quarter was that those retailers, based on where they were at in their omnichannel journey and in particular on the sort of the ecommerce side, they had more work to do or one could say perhaps farther behind than anticipated.

And so from a retailer perspective, running a fulfillment enablement campaign was a higher priority than an analytics enablement campaign. It's not to say they're not important. They're absolutely important and nothing's changed relative to our belief on the importance of analytics longer term. It's just a dynamic that we're happening to notice right now relative to where retailers are at in their journey and prioritizations retailers are making.

Jeff Houston

And then last question for me is looking at the sales force it was great to see that you had a bunch of net adds in the quarter. Could you talk a bit about the background of these new hires, those with more experience versus the recent college graduates and kind of how that's compared with in the past?

Kim Nelson

Sure. So as it relates to from a quantity of sales hires, that part is consistent in the fact that we still get many of our hires right out of college. And that tends to -- those individuals tend to join us right when they've graduated college, so it tends to show up either in Q2 or Q3. This year you saw that reflected in Q2 with those folks joining in June. So from a quantity I would say there isn't really much of a difference there. But as it relates to, then, within that population, we're getting success in hiring folks that have two to three years of experience where they were at a company, sort of their first job out of school and then have chosen to come to SPS Commerce, so still relatively new in their career but not their first job out of college.

So I would characterize our approach in 2016 which is to look to acquire great talent both right out of college as well as some with some years of experience. We're having success there and we expect that to continue. But from a quantity of heads or quantity of adds, it is still going to be skewed towards those folks right out of college.

Operator

And I am showing no further questions at this time. Ladies and gentlemen, this will conclude today's conference. Thank you for your participation and have a wonderful day.

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