Cornerstone OnDemand (CSOD) Adam Miller on Q2 2016 Results - Earnings Call Transcript

| About: Cornerstone OnDemand, (CSOD)

Cornerstone OnDemand, Inc. (NASDAQ:CSOD)

Q2 2016 Earnings Call

August 04, 2016 5:00 pm ET

Executives

Alexandra Geller - Investor Relations Manager

Adam Miller - Founder, President & Chief Executive Officer

Brian L. Swartz - Chief Financial Officer

Analysts

Mark R. Murphy - JPMorgan Securities LLC

Patrick D. Walravens - JMP Securities LLC

Scott Berg - Needham & Co. LLC

Brent Thill - UBS Securities LLC

Jesse Hulsing - Goldman Sachs & Co.

Michael Nemeroff - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Justin A. Furby - William Blair & Co. LLC

Brendan Barnicle - Pacific Crest Securities

Brad Sills - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Raimo Lenschow - Barclays Capital, Inc.

Operator

Good day, ladies and gentlemen, and welcome to Cornerstone OnDemand Second Quarter 2016 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded.

And now I'll turn the call over to Alexandra Geller, Manager of Investor Relations for Cornerstone OnDemand. Please begin.

Alexandra Geller - Investor Relations Manager

Good afternoon, everyone. And welcome to Cornerstone OnDemand's second quarter 2016 earnings conference call. As always, today's call will begin with Adam Miller, Chief Executive Officer, who will provide a brief overview of our performance, and then Brian Swartz, Chief Financial Officer, will review some key financial results for the quarter, which ended on June 30, 2016. Later, we will conduct a question-and-answer session.

By now, you should have received a copy of our press release, which was released after the market closed today and was furnished with the SEC on Form 8-K. You can also access the press release and related investor materials, including detailed financials on our Investor Relations website. As a reminder, today's call is being recorded, and a replay will be made available following the conclusion of the call.

Our discussion will include forward-looking statements including, but not limited to, statements regarding our business strategy, demand for our products, certain projected financial results and operating metric, product development, client satisfaction and retention, client attrition rate, market or business growth, our revenue run rate, investment activity in our business, visibility into our business model and results, the reduction of DSOs, the effect of capitalized development costs, spending on R&D, professional services and other aspects of our business are appraisal of our competitors and their products, and our ability to compete effectively.

Forward-looking statements involve risks, uncertainties and assumptions. If any of the risks or uncertainties materialize or any of the assumptions prove incorrect, actual results could differ materially from those expressed in or implied by the forward-looking statements we make. These risks, uncertainties, assumptions, as well as other information on potential factors that could affect our financial results are included in today's press release and the Risk Factors section of our most recent Form 10-K and subsequent periodic filings with the SEC.

During the call, we'll be referring to both GAAP and non-GAAP financial measures. All financial figures discussed today are non-GAAP, unless we state that the measure is a GAAP number. The reconciliation of our GAAP to non-GAAP information is provided in the press release and on our website.

Please note that we are now using the term billings rather than bookings. But no changes have been made to the definition of this metric. In addition, we have made some changes to the definitions of certain of our other non-GAAP measures, in part based on recently published SEC guidance on the use of non-GAAP financial measures. To ensure that our non-GAAP operating results be evaluated on a comparable basis, our historical non-GAAP financial measures have been adjusted to match these updated definitions. Please refer to our press release for a summary of current period and historical changes to these non-GAAP financial measures.

With that, I will turn the call over to Adam.

Adam Miller - Founder, President & Chief Executive Officer

Thanks Alex, and thank you to everyone joining us today. I am very pleased to report that even with Brexit, Cornerstone had another strong quarter in Q2.

GAAP revenue for the second quarter came in at a record $107 million, representing year-over-year growth of 30%. Billings grew 29% on a constant currency basis and 17% on a reported basis. And our non-GAAP net income for the second quarter in a row came in at near breakeven with margin improvements across all operating expenses, most notably in sales and marketing, putting us firmly ahead of our profitability goals.

In the second quarter, we grew our client base organically to include more than 2,700 enterprise and mid-market organizations from all over the world. New client additions include Nokia Solutions and Networks, the world's leading toy retailer, Admiral Group, Australia's largest department store group, Hong Kong Airlines, HSN, India's largest media conglomerate, the leading luxury French fashion brand, one of the world's leading media and entertainment companies, ASML Netherlands and McDonald's Germany and many more. With a dollar retention rate that's averaged 95% since 2002, one of the hallmarks of Cornerstone since our earliest days has been our ability to maintain industry-leading levels of client satisfaction.

Today, I'm proud to announce that we are well on our way to doing it again in 2016. Our combination of growth and retention has allowed us to grow our subscriber base to over 26 million strong, which continues to represent one of the largest subscriber bases of any software provider in the world. Now as many of you know, Cornerstone has a strong global presence. We have users in 191 countries using the platform in 42 languages. A little more than one third of our business is international today. As a result, Brexit did impact us, particularly with regard to our deferred revenue. Brian will discuss the specific implications of Brexit on our financials and our plans to address it going forward.

Despite recent challenges posed by foreign exchange fluctuations, we remain very bullish about the global opportunity for Cornerstone. We've continued to win some of the world's largest accounts, selling around the world with direct sales operations in North and South America, EMEA and APAC. We've had consistent success from our EMEA team since we first established our presence in that region in 2007 and despite the current situation in the UK, there have been no indications that that will change.

We've seen no direct impact on our European sales operations resulting from Brexit, and finished strong in Q2, even in the UK. Our international business today extends far beyond Western Europe. This summer I had the chance to take an extended business trip to Japan and China to work with our team in Asia. For my many conversations with customers, prospects and partners, it has become abundantly clear to me that we have strong product market fit in both Japan and China.

Japanese and Chinese businesses, particularly those focused on global expansion, have become very eager to implement talent management best practices. And I believe the long-term opportunity for us in both of those markets is significant. We believe the economic growth in China, with approximately 40 million new jobs created in the last three years alone, combined with the desire there to adopt western practices to manage their global workforces, creates a strong opportunity for Cornerstone.

While penetrating state-owned enterprises in China may be challenging, we feel there's a large market of privately owned enterprises, looking to effectively manage their rapidly growing workforces, which presents a right opportunity for Cornerstone. But we believe the even bigger opportunity for us is Japan. The buyers I met with in Japan, which has a significant concentration of large enterprises, understand better than ever that effective talent management is instrumental to globalization. We already have an impressive client base in Japan that spoke publicly while I was there about the success they're having with Cornerstone.

We expect these traditional Japanese reference accounts will help position us strongly in the market. To put it in perspective, I believe Japan could become a top five market for Cornerstone and today it ranks at only 15th for us.

Back in the States, we remain hard at work on our operational excellence initiatives. As our breakeven results in the first half of the year demonstrate, our focus on operational excellence is paying off. We believe these results validate the significant efforts; our global team has collectively made to drive greater efficiency in the business, while maintaining our top-line growth.

The good news is that not only do these many operational initiatives drive margin expansion and profitability, but at the same time, many of them increase operational efficiency, elevate client satisfaction, and provide incremental revenue opportunities.

Furthermore, we've identified a number of additional opportunities for incremental margin expansion in the future. We believe that by 2018 we can achieve operating margins of 10% or higher, and free cash flow margins of 16% or higher. We expect these margin improvements to be driven by improvements in cost of sales, G&A, and most significantly sales and marketing.

Given our first half of this year performance, we believe we are well on our way to achieving our targets. Even as we drive profitability through operational excellence, we have maintained our focus on growth. As I've discussed in the past, one of the biggest opportunities we see for growth is right within our installed base. There are three primary elements to achieving strong growth from the installed base.

First, is solid retention. And as I mentioned, we are on track to once again maintain our 95% retention rate we've had since inception. The second component is a client sales team capable of up-selling the installed base. Our efforts to restructure our client sales organization, over the last couple of years are now paying dividends. Approximately 40% of our clients now use three or more Cornerstone products, and 70% use two or more.

In Q2, our client sales team delivered one of its strongest performances in the last 18 months. The second quarter saw strength in our relationships, with many existing clients, including upsells to Medtronic, ResCare, one of the world's largest pharmaceutical companies, and a big four accounting firm, among many others.

The third component is to provide that client sales organization with compelling products to sell. Over the last few years, we've essentially doubled the size of the Cornerstone platform. And now have several suites of products. While we are best known for our learning suite, more than half of our clients have our performance suite. And today we are seeing significant upsell volume, attributable to the strength of our Recruiting suite.

We believe Cornerstone Recruiting is now the best enterprise applicant tracking system available in the market. In Q2 2016, we released our Analytics suite, with Cornerstone Reporting providing historical reports, Cornerstone View enabling data visualization, Cornerstone insights, providing predictive analytics, and Cornerstone planning, supporting full workforce planning, we now have a strong fourth suite to complement our leading talent management platform.

We believe the opportunity within our install base remains a tremendous area of potential growth for the business, particularly as we continue to invest in innovation and evolving our best-of-breed talent solutions.

With that, I'd like to turn it over to Brian to discuss our financial performance in more detail.

Brian L. Swartz - Chief Financial Officer

Thanks, Adam. And good afternoon, everyone. Today I'd like to do three things. First, I want to clearly explain the impacts that Brexit has had on our financial results. Second, I'd like to discuss our Q2 financial and operating performance. Including some changes to the definitions of our non-GAAP financial measures, and then finally, I'll provide an update to our 2016 outlook.

But before I begin, since this is my first earnings call as Cornerstone's new CFO, I would like to provide some insights into my approach to investor relations. I believe it is important to be as transparent as possible and provide you with the necessary information to understand our strategy and measure how we are progressing against that strategy as well as any other additional relevant information to help you value our business.

I have received a significant amount of constructive feedback since joining Cornerstone last quarter. A number of investors have asked for additional granularity on some of our disclosures, specifically, the historical software and services revenue breakdown, expectations around future billings and the impact of foreign exchange. As a result, we have made several positive changes, which you will see today.

First, in addition to disclosing the software and services revenue breakdown for the current and year ago quarters, we have now included the historical breakdown for the past six quarters in today's press release.

Second, I will provide some commentary regarding anticipated billing seasonality in the third quarter. And, third, we have provided more clarity around the impact of foreign exchange by providing revenue and billings growth on a constant currency basis.

In furtherance of this transparency, I have updated the Investor Relations section of our website to include two new financial summaries. The first is a one-time detailed example of how we calculate constant currency revenue and billings. And the second is a supplemental operational and financial highlights schedule, which summarizes our historical trends of key metrics, including non-GAAP financial measures, and will be updated each quarter going forward.

I hope these enhancements are helpful. And I welcome your continued feedback into the future.

Now let's discuss the impact of Brexit and the related devaluation of the British pound. I would like to spend some time explaining our worldwide legal structure to help provide clarity on the accounting impacts from the devaluation and then explain what we're doing about it.

Legally, Cornerstone is structured, so that essentially all of our sales outside the U.S. flow through our UK subsidiary, which has a functional currency of the British pound. The legal structure results in a two-step currency exchange process, where the non-British pound currencies are first converted into the British pound, the functional currency of the UK sub, and then the financial statements are translated from British pound into U.S. dollars, when we consolidate the UK sub with our U.S. parent company for financial reporting purpose.

Accordingly, we are impacted by both the currency fluctuation between the non-British pound currencies and the pound, as well as movement between the British pound and the U.S. dollar.

As a reminder, in 2015, about one-third of our revenue came from outside the U.S. Given the sizable international business, there is an accounting impact related to the two-step currency exchange. The first step for the conversion process I mentioned above, results in recording income or expense in the other income and expense line item in the income statements. The amounts for the second quarter were not significant.

The second step for the translation process has a significant headwind to the historical billings calculation, as well as future revenue, which I'll discuss further when we get to the outlook section in a moment. We have not entered into any foreign currency hedging transactions and are actively working with our advisors to mitigate foreign currency risk going forward given our legal structure. I'll keep you updated on future calls and in the meantime, we provided some sensitivity analysis on further currency movement in our updated outlook.

Despite the currency impact, as Adam mentioned, the underlying health of our business is very strong. And we are very pleased with our performance this quarter and excited about the runway ahead. With that, I'd like to summarize our quarterly financial performance.

In the second quarter, GAAP revenue was $107 million, representing a year-over-year increase of 30%, or 32% on a constant currency basis. As outlined in our press release, in the second quarter the split between subscription and services revenue was 78.7% and 21.3%, respectively, which is generally in line with historical average.

As I mentioned earlier, and as many of you have been requested, please note that in today's press release, we are providing the breakdown between subscription and services revenue for the last six quarters. Additionally, during the first half of 2016 due largely to the company's continued success of the top end of the market for new sales, we experienced a higher percentage of services revenue relative to total deal size. While the impact from Brexit on revenue was relatively small, the impact on billings was more significant.

Please note our reference to billing is the same metric that we previously referred to as bookings and is calculated by taking GAAP revenue plus the change in GAAP deferred revenue from the balance sheet. The second quarter year-over-year constant currency billings increased 29%, while our reported billings of $106 million increased 17%. The reported growth rate was significantly impacted by the devaluation of the British pound and, therefore, understates the overall performance and actual growth of our business.

Notably, our reported billings would have been about $5 million higher, or about $111 million, if used a change in deferred revenue from the statement of cash flows, which uses the average FX rates over the quarter as opposed to the quarter-end spot rate, which is used to calculate deferred revenue on the balance sheet.

A few other key metrics, the size of our client base increased to 2,730 as of June 30 representing 60 net client additions during the quarter and our user base increased to nearly 26.3 million users representing 1.3 million net user additions during the quarter.

Additionally, we added 41 employees in the second quarter, bringing up to 1,722 employees. Our total employees increased 14% year-over-year and 2% sequentially. Our gross margin was 69.6% in the second quarter, down 70 basis points from 70.3% in the prior year. This reduction was due to a slightly higher percentage of both services revenue during the quarter, which is simply a function of timing, as well as services work performed by third-party partners.

With respect operating expenses as a result of strong execution on our operational excellence initiative, we experienced year-over-year improvement in all expense line items. Sales and marketing expense was 48% of revenue in the second quarter, down 750 basis points year-over-year. R&D expense was 9% of revenue down 120 basis points and G&A expense was 12% of revenue, down 30.

Overall, this resulted in an operating income margin of 0.1% in the second quarter of 2016, which represents an 830 basis point improvement from our operating loss margin of 8.2% in the prior year. We're extremely pleased with his performance, particularly in sales and marketing. It's worth noting that in the first half of 2016 on a year-over-year basis, we saw a 620 basis point improvement in sales and marketing, which is roughly half of our target in improvement in this area by 2018 after just two quarters.

I'm also very pleased to report for the second quarter in a row we exceeded our profitability goals and reported a net loss for the second of 2016 near breakeven at approximately $73,000 compared to a net loss of $8.7 million, or $0.16 per share in the prior year. This performance is substantially ahead of our expectation and continues to highlight our ability to drive operational excellence throughout our business.

With regard to cash flow, free cash flow which we define is operating cash flow, less capitalized software and capital expenditures was negative $1.7 million in the second quarter of 2016, compared to negative $19.3 million in the prior year. The year-over-year improvement is a direct result of our improved profitability.

Let me turn to the balance sheet. We continue to maintain a well-capitalized balance sheet. As of June 30, our total cash, accounts receivable in short and long-term investments was approximately $401 million. Additionally, as of June 30, we had $234 million in carrying value of long-term debt.

Our deferred revenue balance was $236 million, as of June 30, compared to $237 million as of March 31, and $190 million as of June 30, 2015 representing a sequential decrease of 0.3% and a year-over-year increase of 24%. The 7% devaluation of the British pound during the second quarter was the primary driver of the sequential decrease in our deferred revenue balance.

Now let we turn to the outlook, which is based on the best information we have as of today, and may change in the future, as we gain additional insight into our Q3 operating results.

Please note that all guidance assumes the U.S. dollar to British pound exchange ratio of $1.3 to £1. The health of our business remains strong and we're very optimistic about the future. However, due to Brexit and the related devaluation of the British pound, we're lowering our previously communicated full year 2016 GAAP revenue guidance from a range of $428 million to $434 million, to a range of $424 million to $428 million.

At the mid-point of $426 million, this represents a 30% constant currency growth over our 2015 revenue of $340 million, and 25% growth on a reported basis. Again, this change is entirely due to Brexit. If the British pound would have further depreciate by 5%, the approximate impact on our full-year revenue would be about $4 million.

For the third quarter, we currently expect revenue between $103.5 million to $105 million. At the mid-point this range represents 26% constant currency growth over the third quarter of 2015 revenue of $87 million, and 19% growth on a reported basis.

With respect to net income, we continue to expect to be profitable in 2016. Although, we are lowering our previous full-year 2016 net income guidance of $2 million to $500,000. This reduction reflects the lower GAAP revenue due to Brexit, the offsetting benefit we capture from having certain expenses denominated in British pounds, as well as our latest view on the strong operating performance we experienced in the first half of 2016 and the continued benefit we expect in the second half of the year. Also as a reminder, for EPS purposes, our current share count of approximately 55 million will increase to approximately 60 million in quarters that we report a profit.

Now let's turn to cash flow. For the full-year 2016, we are lowering our previously communicated guidance for free cash flow of approximately $34 million to $27 million, which represents a 6.3% margin at the midpoint of the revenue guidance range. This is in comparison to 2015 free cash flow of $15 million for a margin of 4.4%. The reduction in free cash flow is entirely due to Brexit. Finally, regarding billings. As a result of Brexit and the associated devaluation of the British pound, we expect our second half billings to be impacted by about 4%. In addition, we expect that the third quarter seasonality will be about 23% of total 2016 billings versus 26% in the prior year.

We are very excited about our future and are particularly proud of our operational excellence and profitability achievement being ahead of plan. Although we have some challenges in Q2 with the Brexit announcements, our business as a whole remains fundamentally strong and we're very excited about our future growth opportunities.

With that, I'll turn it back over to Adam.

Adam Miller - Founder, President & Chief Executive Officer

Thanks, Brian. As our first half of the year results demonstrate, Cornerstone continues to see strong global demand for our state-of-the-art talent management solutions, and we are well on our way to full-year profitability. I want to thank our entire global team for their tremendous work as well as our ongoing commitment to client success in operational excellence.

We will now take your questions.

Question-and-Answer Session

Operator

Our first question comes from line of Mark Murphy from JPMorgan. Your question please.

Mark R. Murphy - JPMorgan Securities LLC

Yes. Thank you very much. Congrats on the breakeven results and the solid constant-currency growth rates. So, Brian, I wanted to start by saying thank you for the additional disclosures. One question on the billings, was there any impact, either positive or negative, outside of FX-related factors? For example, did anything change materially in terms of invoicing duration or timing or ramp deals, late starts, anything like that?

Brian L. Swartz - Chief Financial Officer

Yes. No, first of all, thanks for the compliments. I appreciate that. In terms of general billing, nothing changed. It was all due to FX. There was slightly less upfront billings, which is pretty consistent with what we've seen in the last couple of quarters due to our success in the upper end of the market, but it was relatively minor and not significant. So it's principally virtually all FX related.

Mark R. Murphy - JPMorgan Securities LLC

Okay, great. And then also, forgive me, I don't know if this is going to be self-explanatory in the new website disclosures, which I have not seen quite yet. But can you tell us exactly what or roughly what percentage of your sales are denominated in pounds? And I was listening carefully. I believe it's essentially the vast majority of all of that international revenue. But for some reason, I had it in my mind that there might have been a couple points of euro or maybe Australian dollar or something like that. Is it possible to just walk us through those exposures?

Brian L. Swartz - Chief Financial Officer

Yes. Let me actually break it down for you. Just for clarity in my prepared remarks, Mark, virtually all of our international revenues flow through our UK entity, so all of them, regardless of what currency, the contracts, that the revenue contracts are denominated in, get converted to British pound. That's why it had such a big impact on our consolidated results.

Mark R. Murphy - JPMorgan Securities LLC

Okay.

Brian L. Swartz - Chief Financial Officer

When you actually look at our UK entity, though, to answer your question, the percentage that is most of the revenue that comes into there is either denominated in euros or pounds. Pounds is about 10% of the total amount, so call it 9% or 10% of our overall sales are actually pound denominated. A large majority of the rest are euro denominated and then there are several other currencies that make it all up. So that's kind of the general breakdown.

I would point you to in our 10-K we do have a segment disclosure in the 10-K, which also shows you roughly the same numbers, and they're based on where the customers and location is. That's how we break it down for purposes of the 10-K, so you can look at it there as well, but all the numbers are generally consistent with what I just quoted you.

Mark R. Murphy - JPMorgan Securities LLC

Okay, great. And so, Adam, I had two questions for you. The first one, we have heard some feedback that SuccessFactors might be downticking a little in terms of its competitive intensity or its presence in deals in recent months. I'm curious if you are observing that. And if so, do you think that that could open up any new opportunities in terms of large enterprise accounts?

Adam Miller - Founder, President & Chief Executive Officer

Yes. What specifically happened is the head of products for SuccessFactors went over to Google and that was their biggest competitive edge from a product standpoint. So I believe that going forward, their products will be a little weaker and we keep innovating, so that gives us the advantage from that standpoint. So we are still seeing them as the number one competitor around the world. And I don't expect that to change any time soon. But our ability to compete with them continues to improve.

Mark R. Murphy - JPMorgan Securities LLC

Okay. So, Adam, the last one I wanted to ask you. I would be curious to get your thought on the frenetic pace of the cloud M&A wave, because I think you've been pretty in tune with it in the past in prior cycles. And so it has not touched the HR realm yet in this wave in any material way. I think we're all wondering if at some point it will. But does the environment – does it feel rational or irrational? Do you think the activity has peaked or there's more to come? Is there any way you would guide us in terms of thinking how Cornerstone can continue to capitalize on all this activity?

Adam Miller - Founder, President & Chief Executive Officer

No, obviously, we don't comment about M&A on these calls. I would just say that obviously the floor has been set for valuations of cloud companies and the justification of the value of these assets, its scale has been demonstrated. Having said that, as you know, there has been tremendous M&A in our space in the past, so there are not very many assets that are independent at this point, and the consolidation has already occurred in this space.

Mark R. Murphy - JPMorgan Securities LLC

Thank you.

Operator

Thank you. Our next question comes from the line of Patrick Walravens from JMP Securities. Your question please.

Patrick D. Walravens - JMP Securities LLC

Great. Thank you. I have two and I'll just lay them out at the beginning. So, Brian, for you now; now that you've had a little period under your belt, I'd love to hear what the positive surprises and the negative surprises have been? And then, Adam, following up on the M&A conversation but maybe sort of its impact on the fundamentals. How, if at all, do you think Microsoft acquisition of LinkedIn might affect the talent management market?

Adam Miller - Founder, President & Chief Executive Officer

Yes. I'll answer first. I think it was a very smart move from Microsoft. I think it helps them defend their position with Microsoft Office and with Outlook in particular as the hub of that positioning. So I think it was a very smart move for them. It has relatively little impact on us. As you know, there had been a lot of talk of LinkedIn in our space. That never actually occurred, and I think this will prevent that from occurring any time soon.

So they now have their hands full working to bolster Microsoft Dynamics, working to bolster Microsoft Office 365 and what they're doing with Outlook. There's obviously a lot of potential synergies between those two groups. And most of it happens outside of our space. But as I have said before, LinkedIn and the success they've had does demonstrate the importance of talent management as a concept.

Patrick D. Walravens - JMP Securities LLC

Okay, cool. Thank you.

Brian L. Swartz - Chief Financial Officer

And, Pat, it's Brian. Just to follow-up on the first question. It's been a whirlwind of a two months. I've obviously enjoyed getting to know the whole team here. What I would tell is I haven't had any of those moments where I found something out and I was like, oh, I can't believe I didn't find that out during the interview. There were none of those (34:45) moments. Everyone has been very transparent from day one. I think there's tremendous opportunity here. The more I get involved with the business and learn it, and it's only been a couple of months, the more I think there's great opportunity to help scale, drive profitability and top line growth. So it's been, like I said, a lot of fun and no negative surprises whatsoever and lots of opportunity in the future, so

Patrick D. Walravens - JMP Securities LLC

Okay, great. Thank you.

Operator

Thank you. Our next question comes from the line of Scott Berg from Needham. Your question, please.

Scott Berg - Needham & Co. LLC

Hi, Adam and Brian. Congrats on a great quarter. Couple of quick ones here. First of all, Adam, can you comment about the demand environment a little bit. We've been picking up on our checks recently that RFP activity in the space seemed to tick up in Q2. And one of the questions we often get is how much longer can this double growth plus rate extend in this space here? And Q2 seems to indicate that there's no end in the sight. Just wanted to see if you guys are seeing the same thing.

Adam Miller - Founder, President & Chief Executive Officer

Yes. As I've said before, we believe there's 400 million potential seats are what we do. The whole industry has fewer than 100 million seats. We have close to 30% of that today. And there's a lot of potential growth around the world. We're seeing opportunities way up market at the top end of the largest enterprises in the world. We're seeing a really green field opportunity down market. As I mentioned earlier in my remarks, there are lots of opportunities outside of the U.S. In fact, even with Brexit, we saw strength in the UK market. So there's tremendous global opportunity. We are now selling around the world and we're seeing really good product/market fit almost everywhere. And our win rates globally continue to improve.

Scott Berg - Needham & Co. LLC

Great. And I guess the follow-up to that, Adam, is you were quite bullish in your prior remarks, specifically on Japan. I wanted to see if you can give us some additional color there, because I know a scenario where you've had some success, maybe had some starts and stops. But your color there or at least your initial comments seem to be the most bullish we've seen internationally in at least several quarters.

Adam Miller - Founder, President & Chief Executive Officer

Yes. So for anybody who has done business in Japan, they know it's a very traditional market that follows its own set of rules. And one of the key components of being successful in Japan is having reference accounts from very respected traditional Japanese firms. We now have those reference accounts. We're working with some of the biggest companies in Japan today. And the reason I'm so bullish after my trip is during my trip I was with them publicly talking to groups of potential prospects, which means not only do we have these companies as clients, but they are actively helping us build our business in the region. And these are companies like Hitachi and Nissan and others who are the biggest companies in Japan. And what they do matters to the rest of the market. So we are now well positioned to grow significantly in that market.

It also, as I've said over the last couple of years, it takes us time to build our presence in markets, especially when we get into a brand new geography. And Japan is one of those markets that takes longer to gestate than others. But once you get it going, it's a very large opportunity. And in particular in Japan, it plays to our strengths. The Japanese market is comprised of many large enterprise companies. That's where we do arguably the best. And we are very well positioned now having reference accounts, a team there, track record and the ability to really grow with the product/market fit.

Scott Berg - Needham & Co. LLC

Great. That's all I have. Thanks for answering my questions.

Adam Miller - Founder, President & Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of Brent Thill from UBS. Your question please.

Brent Thill - UBS Securities LLC

Thanks. Adam, on the customer number, that was cut in half year-over-year. Can you just explain what's happening there on the customer number? And I would assume that's you're just getting larger transactions. And on the flipside, can you also talk about the rebuilding of the Mid-Market and what you're starting to see in that group in productivity as you head into the second half of the year?

Adam Miller - Founder, President & Chief Executive Officer

Yes. Thanks. That's a very fair question. And it's difficult for you guys to see what's really happening there, because of the fact that we're giving net client adds. So actually our gross client adds were in line with expectations and with our own internal plans. But the net number was down because of churn at the bottom end of the market. As we've gone further down market, as you all know, there is higher turnover in that segment of the market, you have companies that are more volatile, they are less viable as businesses. So if you have a company with 300 employees, there's a good chance that they're going to get acquired or merged or go out of business in some way. And you end up with more churn in that segment of the market.

And having said that, our Mid-Market business does have opportunity to continue to improve, particularly in the second half of this year, and we are on track to do that. And we have reaffirmed our 95% dollar retention rate, which shows that we continue to have excellent levels of service across the board and we're keeping all of our major accounts. And that's what really helps us build the business over the long-term.

So the reason the net number is low is because of more churn at the bottom end of the market. And, quite frankly, we are addressing that as well. Obviously we can't control if these companies have a corporate transition or bankruptcy, but to the extent we do have some control over it, we're going to do what we can to minimize churn in that segment as well.

Brent Thill - UBS Securities LLC

Thanks, Adam.

Adam Miller - Founder, President & Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of Jesse Hulsing from Goldman Sachs. Your question, please.

Jesse Hulsing - Goldman Sachs & Co.

Yes, thanks for taking my question. I have two. First to follow up on Brent's question about the Mid-Market business. I think on prior calls you've talked about it may be starting to come back and be a positive contributor in the second half, and I was wondering if that's what you're still expecting? And then second, I was hoping you could give us an update on the recruiting module and how you're doing with that part of your business, and I guess competitively versus Taleo what are you seeing?

Adam Miller - Founder, President & Chief Executive Officer

Great. So on Mid-Market, yes, we feel we're on track to have an uptick there in the second half of the year. The team has been extremely stable this year. That was the issue we had last year was instability on that team. And lower Mid-Market, our major accounts team has been a consistent performer, including the first half of the year, but we expect that to improve in the second half of the year as well.

With regard to the second part of your question on recruiting, we are seeing really good traction in recruiting now. Recruiting was part of the reason we've had strong success in the first half of the year. We're seeing recruiting attached to a lot of our big deals now. So it's not just a Mid-Market play. This is a large enterprise play as well. In certain segments we're leading with recruiting, like in education. And with regards to Taleo, I believe we have reached the point of parity, and because of our faster release cycle, our faster rate of innovation versus Oracle, for example, we are able to now have the state-of-the-art enterprise solution for applicant tracking.

So we believe we have the killer app now for recruiting out there for large enterprises. We continue to enhance that product, continue to extend our integrations. A lot of the work we're doing with Edge is specifically in the area of recruiting. And recruiting has become a big part of client sales as well. So we're starting to up-sell it to the installed base. In almost all of those cases, we are replacing either Taleo or Kenexa.

Jesse Hulsing - Goldman Sachs & Co.

Thanks, Adam. Very helpful.

Adam Miller - Founder, President & Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of Michael Nemeroff from Credit Suisse. Your question please.

Michael Nemeroff - Credit Suisse Securities (USA) LLC (Broker)

Hey, guys. Thanks for taking my question. Great quarter. And Brian, again, thanks for those additional resources. Those are very helpful. Adam, I'm just trying to square your comments on the customer churn towards the low-end of the market with the re-release of that Mid-Market product over the last couple of quarters. Is that as a result? I mean, is this planned? I'm just trying to square the two comments.

Adam Miller - Founder, President & Chief Executive Officer

No. So thanks for bringing that up, because it gives me a chance to clarify. SMB is not included in our client accounts. We've never included what we consider small business, which is companies with fewer than 250 employees, in our client count. So where the churn is happening is what we call major accounts, companies with between 250 employees and 1,000 employees. And as you can imagine, the ones going out of business or getting acquired away, are the ones at the lower end of that segment. So they are closer to 250 employees than they are to a 1,000 employees. And that is being offset obviously by the strength we have at the higher end of the market, and the 95% retention rate we've experienced since inception.

Michael Nemeroff - Credit Suisse Securities (USA) LLC (Broker)

That's great. Thanks, Adam. And then...

Brian L. Swartz - Chief Financial Officer

Hey, Mike, I'm sorry.

Michael Nemeroff - Credit Suisse Securities (USA) LLC (Broker)

Go ahead, Brian.

Brian L. Swartz - Chief Financial Officer

Mike it's Brian. Just one more point of clarity. I think the product you're referring to the new release was the growth addition product, which is the SMB product, which was released in November of 2015. So that product is not in the client accounts that Adam was referring to. I just wanted to clarify that product release late last winter or I guess early in the winter, in the November timeframe, was related to that SMB market.

Michael Nemeroff - Credit Suisse Securities (USA) LLC (Broker)

So that's helpful, Brian. Thanks. And then as it relates to Brexit and the tone of business in Europe, aside from the FX track that we saw, and thanks for helping us work through that very explicitly. Are you seeing any hesitation or drop in demand from that region? We haven't heard it too much out of some of the companies that have already reported, but every once in a while we're hearing it?

Adam Miller - Founder, President & Chief Executive Officer

We've seen no impact at all. In fact, I was particularly concerned, because we had a lot of business closing at the very end of the quarter from the UK and all of that business closed. So there was no direct operational impact from Brexit, obviously a huge FX impact, but not an operational impact. The one area that Brexit does bring up for prospects and for the sales process, is around data security and data privacy, because of our data center being in London. So, our primary European data center is in the UK. And there are some potential challenges to keeping it in the UK over the long term. But it depends on how the UK and the rest of the EU work out their data privacy concerns.

Michael Nemeroff - Credit Suisse Securities (USA) LLC (Broker)

That's helpful Adam. And then lastly for Brian, I think Adam you had mentioned you've identified some further areas where you can reduce the cost going forward to expand the margins and get the free cash flow up. Brian, is it on the COGS side or the expense side, where you've identified some of those easy or low-hanging fruit on those?

Brian L. Swartz - Chief Financial Officer

Yeah, I think it's more on the expense side. I mean just to give you an example. We're going to be investing kind of more directly in sourcing and procurement. I think there's a real opportunity with the services we buy from third parties to really have an impact on the rates we're paying, as an example. So, it's spread amongst all the operating expenses and there's some in COGS as well.

Michael Nemeroff - Credit Suisse Securities (USA) LLC (Broker)

Great. Thanks so much for taking my questions.

Adam Miller - Founder, President & Chief Executive Officer

In particular COGS will improve as what I call program accelerate takes hold. This is a big project that takes a long time. And we're not going to see the impact this year. That's going to start to have an impact in 2017. And will be I believe meaningfully impacting our cost of sales and improving our gross margin accordingly.

Michael Nemeroff - Credit Suisse Securities (USA) LLC (Broker)

That's great. Thanks for taking my questions.

Adam Miller - Founder, President & Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of Justin Furby from William Blair & Company. Your question, please.

Justin A. Furby - William Blair & Co. LLC

Thanks, guys. Congrats. I'll try to put a lot of things in one question. I want to ask on billings, I guess you are guiding for Q3 to be quite a bit lower as a percentage of the full year, as it was last year. And I'm not saying the Street is right on the full year. But if they are and you take the 23% of that Brian, it says something like 8% growth in Q3 for billings, and I know you have some FX impact, but it shouldn't be nearly as big as it was in Q2 in terms of the deferred revaluation, so I'm just struggling as to the pipeline commentary and what we're hearing around that versus the guidance and why billings would be anywhere near that level?

And then I guess on cash flow, just help me understand the 20% cut on the guidance. I guess I thought the pound, it's only 10% of your business. So wouldn't that be the real economic exposure there? And so any help on that would be appreciated. Thanks.

Brian L. Swartz - Chief Financial Officer

Yeah, no, absolutely, Justin. Let me see if I can help you on both of those. First of all, on the billings guidance for Q3 in my commentary, our full-year plan is right in line with what we expected. It's really a timing issue between Q3, Q4. So obviously the numbers in the second half are impacted by FX and then just given what we're seeing in our pipeline, it's just a timing issue of when we expect things to close between Q3 and Q4. So the pipeline remains strong and we are right on track. I just wanted to give you some commentary to make sure everyone understands what we're headed for at least Q3 and Q4 based on what we know today.

On your second question, with respect to cash flow, it's really also a timing impact, right. It's a question of when we collect cash versus when we recognize things at our P&L. So because there's only a half a year left and obviously Brexit happened at the end of June, we feel basically the 100% impact from the cash, but the P&L impact, so to speak, both on the OpEx, obviously more on the revenue, is spread out over time. So it's really just a function. And to give you an example, with December 31 and we were expecting to collect $10 million and the currencies moved by 10%, we would collect $9 million, you wouldn't feel any of that in your P&L until the future years. But you would feel 100% of it on the cash flow. So that's the change for the numbers.

The other thing I wanted to point out, just to help everyone with expectations setting for the second as well. We obviously had a great first half of the year, break-even results. We expect to be profitable for the full year, as we guided to. We do expect our profit to come in Q4 versus Q3, so just from a timing perspective as it helps you build your models and think through Q3 and Q4. Q3 should be hopefully be break-even or positive. But it could be a negative with a loss in Q4 generating the profit for the year. So I wanted to give that commentary as well since you asked the question.

Justin A. Furby - William Blair & Co. LLC

Okay. Thank you.

Brian L. Swartz - Chief Financial Officer

Welcome.

Operator

Thank you. Our next question comes from the line of Brendan Barnicle from Pacific Crest Securities. Your question please.

Brendan Barnicle - Pacific Crest Securities

Thanks so much. Adam, you highlighted the nice profits (51:12) you're looking at in Asia-Pac. I was wondering if you could give us any update on Latin America. I know that had turned around in the last couple of quarters. And then also in the public sector, which I know has been sort of hit-or-miss over the last couple of quarters.

Adam Miller - Founder, President & Chief Executive Officer

Yeah. So Latin America, we are doing extremely well in Mexico. Our focus has been specifically on Mexico and Brazil. Brazil is a little bit like Japan in that, it's just a longer time to gestate. So Mexico had a shorter gestation cycle. We're doing quite well. We've ramped up our investment there and we're seeing the fruits of that investment. Brazil is taking a little bit longer.

In public sector, we've done quite well in education this year, particularly in K-12 and in the non-profit space, we are having mixed results in government, and I think because this year has been a much more tumultuous election cycle, we're seeing less activity than we originally expected in federal, as a direct result. And I don't know that that's going to change this year, until the election happens.

Brendan Barnicle - Pacific Crest Securities

Great. That's helpful. And just a quick one for Brian. So far through the first half of the year, CapEx is running pretty well below where it was last year. I'm wondering if we should be modeling that same kind of run rate for the back half or do you see some kind of catch-up happening in the back half?

Brian L. Swartz - Chief Financial Officer

Yeah. We think it'll be less in Q3 and more in Q4. But it should be below last year's number, and not at the same level. But it should come – whatever amount comes, will come in the Q4 timeframe.

Brendan Barnicle - Pacific Crest Securities

Okay. Great. Thank you.

Operator

Thank you. Our next question comes from the line of Brad Sills from Bank of America Merrill Lynch. Your question, please.

Brad Sills - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Hey, guys. Congratulations on a nice quarter. Adam, it sounds like you're more positive on kind of opportunities for the strategic accounts business, I guess the very large deals in some of your comments. Can you talk a little bit about what you saw this quarter in that segment of the market both on signings and then on pipeline as well, please?

Adam Miller - Founder, President & Chief Executive Officer

Yeah. So the pipeline has been pretty stable throughout the year. It continues to grow as we build out that team around the world. And the deals are long sales cycles. So we are well on our way in a number of large opportunities. We expect those to happen more towards the end of the year. It's just typically when these largest deals close and that's been true really our entire history. I don't think it'll be any different this year.

Brad Sills - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Got it. Great. Thanks, Adam. And then just one on Workday, we're hearing that they've been in the market now for some time and they've kind of been having less impact than maybe thought initially. Can you comment a little bit on what you're seeing with Workday and some of the sales cycles? Thank you.

Adam Miller - Founder, President & Chief Executive Officer

Not less than I thought. So, they've had the same impact I've expected the whole time and I've been talking about for a while.

Enterprise learning is a very complicated area that requires an incredible amount of functionality to meet the needs of global companies. And we are uniquely positioned to support the largest companies in the world, with their global training and development requirements. And I think that remains true and that's the reason we haven't seen a lot of new entrants into the space. We still spend a majority of our R&D on learning. And all the various products we have in the learning and development area. And that keeps our competitive edge in that space.

Brad Sills - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Great. Thanks, Adam.

Adam Miller - Founder, President & Chief Executive Officer

Thank you.

Operator

Thank you. And our final question for today comes from the line of Raimo Lenschow from Barclays. Your question please.

Raimo Lenschow - Barclays Capital, Inc.

Thanks for taking my question. And congrats as well from me. Brian, the legal structure seems kind of slightly on the odd ends, I mean we don't have it for any other companies. Now that you're in there and reviewing, is there a sense to kind of maybe have a look at that, while you're going through that?

Brian L. Swartz - Chief Financial Officer

Yeah. As you can imagine, Raimo, we've already been doing that. We're working on it for well over a month now. It's hard for me to speculate about exactly what we might do or what might change. But we're looking to optimize the structure. I mean the bottom line is we do not want to have volatility in our results, because there's huge movements in any one or baskets of currencies. And so there are lot of different alternatives that we're looking at and as we have more clarity as to exactly what we're going to do, I'll certainly talk to you more about that.

Raimo Lenschow - Barclays Capital, Inc.

Perfect. Thank you.

Operator

Thank you. And this does conclude the question-and-answer session. I'd like to hand the program back to Adam Miller, CEO, for closing remarks.

Adam Miller - Founder, President & Chief Executive Officer

Thank you all for joining the call. And we hope to catch up with you soon at one of the many investor conferences coming up. Thank you.

Operator

Thank you, ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.

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