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Zix Corporation (NASDAQ:ZIXI)

Q1 2012 Earnings Call

April 24, 2012 5:00 EST

Executives

Geoff Bibby – VP Corporate Marketing

Rick Spurr – CEO, Chairman & COO

Mike English – CFO

Analysts

Mike Malouf – Craig-Hallum

Ian Kell - Northland

Operator

Good day, ladies and gentlemen and welcome to the First Quarter 2012 Zix Corporation Earnings Conference Call. My name is Melanie and I'll be your coordinator today. (Operator Instructions) I would now like to turn the call over to Mr. Geoff Bibby, Vice President Corporate Marketing. Please proceed.

Geoff Bibby

Thank you, Melanie. Thank you for joining our 2012 Q1 conference call. You can find our earnings press release on our investor website at investor.zixcorp.com. The earnings release contains instructions for accessing a recording of this call. Our Chairman and Chief Executive Officer, Rick Spurr, will provide an overview of the company's performance in the quarter, and our CFO, Mike English, will give you details of our financial results.

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

Rick and Mike will provide forward-looking statements on matters such as forecast of revenues, earnings, operating margins and cash flow, projections of our contracts or business, and comments on trend information. The company undertakes no obligation to publicly update or revise any forward-looking statements. Forward-looking statements are subject to risks that could cause actual results to differ materially from our expectations. The risk factors section of the company's most recent Form 10-K filing with the SEC gives examples of those risks.

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

Now I am pleased to turn the call over to Rick.

Rick Spurr

Thanks, Geoff. Good afternoon, everyone, and thank you for joining us today to discuss Zix Corporation's first quarter financial results. I am pleased to report another very solid quarter for the company. From a top line perspective, we achieved record revenue in the first quarter of $10.3 million, which was up 11% over the first quarter of last year and surpassed our revenue guidance for the quarter of $10 million to $10.1 million.

We also, for the quarter, exceeded our guidance for non-GAAP net income per fully diluted share. Non-GAAP net income for the first quarter was $2.9 million, up 13% over $2.5 million in the first quarter of last year. Non-GAAP net income for the first quarter, expressed on a fully diluted per share basis of $0.04 per share, was up 25%. This per-share increase is not evident due to rounding. The 25% increase is a function of both the non-GAAP net income increase and the reduced number of outstanding shares due to our share repurchases.

New first year orders for the quarter grew 14% to $1.7 million, compared to $1.5 million in the first quarter of last year. Later in the call, I will go into more detail on the breakdown of the new first year orders and some positive changes in their makeup, including a very strong performance from our large OEM partners.

Total bookings for the first quarter came in at $9.1 million, up slightly over the first quarter of last year, and our backlog at the end of the first quarter of 2012 remained healthy at $52.3 million. We continued our consecutive quarterly string of GAAP profitability, achieving GAAP net income of $2.4 million.

On a fully diluted share basis, GAAP profitability was $0.04 per share, as compared with $0.03 per share in 2011, an increase of 11% over the first quarter of last year. This represents our ninth consecutive quarter of GAAP profitability. Our business continued to generate strong cash flow, with $2.5 million in cash flow from operations during the quarter. We ended the quarter with cash balance of $18 million, which was down $2.7 million from our year-end cash position of $20.7 million. The decline in cash was directly attributable to share repurchases during the quarter as part of the stock buyback plan we have in place. Mike English, our CFO, will provide more details on the buyback later in the call.

As we've noted before, our healthy balance sheet and the strong cash flow we generate allow us to continue to invest in our growing business while also driving value to our shareholders through a share repurchase program. As I noted on our last conference call, we believe 2012 will be a very strong year for the company as momentum begins to build.

Looking at the competition of our new first-year orders for the first quarter, I am pleased to report a significant increase coming from our large OEM partners. In fact, for the first quarter, our OEM partners represented the highest new first-year order contribution in the history of our company, and we see this positive momentum continuing to build.

Google was up 49% over the first quarter of last year, and Symantec increased 115% over last year. These very strong growth rates reflect the increased activity in the marketplace for email encryption, strengthening field-level relationships between our sales teams and theirs, and the partners' growing capability and confidence in selling Zix Corp's services. We continue to work diligently with these partners to continue this sales momentum, and also to attempt to integrate our products even further, to enhance our joint competitiveness in the marketplace.

In addition to these strong OEM partner results, our VAR and managed securities services partners, we call MSSPs, contributed 25% of new first-year orders during the quarter. We continue to invest in these VAR and MSSP channels. In 2011, we increased the total number of these partners by 65%. Most of these were added late in the year, and there is a typical lag time before they become productive. So we hope to see contribution from these channels grow over the course of 2012.

All of these third party reseller relationships--OEMs, VARs, and MSSPs--take a long time to create and nurture, but as you know, they are key to extended reach and coverage and the financial leverage in our business model. Our ever-vigilant focus on this distribution strategy is starting to pay off as, together with these partners, we are poised to capture increasing industry demand for email encryption.

Turning to direct sales, our enterprise sales team, which targets larger customers of 1,000 or more employees, was the one area of weakness that we saw during the quarter. But we believe this was due to several larger deals that moved beyond the quarter, one of which is closed now and others that are still active and represent situations where competition has been eliminated. We are very encouraged by what we are seeing in the enterprise sales team's pipeline and expect to see solid growth from them as we move through the remainder of the year.

Our corporate sales team, that sells to the small and medium business segment, where companies have less than 1,000 employees, contributed a solid 45% of new first year orders during the quarter. We look for continued growth throughout the year from this group as demand and leads from this segment also continue to grow.

In summary, with regards to new first year orders, the partner results are impressive and position us for broad reach and coverage in the enterprise and corporate direct sales, although affected by Q1 seasonality, appear to be positioned for a good year as demand, measured by inbound leads and our sales pipeline seems to be increasing.

Now, let's discuss our leadership position in the industry. We have a very sustainable and defensible competitive advantage in the email encryption market. Due to our industry-unique architecture, we offer the only fully transparent email encryption service available today. This architecture includes our Zix directory, which has been building for the past 10 years and represents a significant barrier to entry. And we are well-positioned to continue to gain market share as our win rate continues to be approximately 70% in the deals where we engage.

Noteworthy is the fact that an increasing number of deals are now displacement opportunities due to older competitors and older technology that is no longer meeting the needs in the market place.

While continuing to expand our competitive advantage and our lead in the email encryption segment of the market is key to to continued market share expansion, a particular focus on ease of use for senders and receivers is key to accelerating market adoption and the overall growth in the size of the market. We believe adoption of encrypted email at the user level is still only 10%. So, the huge opportunity we have is moving adoption up to 30%, 50%, or even 100%, as we add more and more customers to the network and as we find more and more ways to make email encryption automatic and transparent to users.

Our most recent innovation to make email encryption automatic and transparent to users is embodied in our ZixGateway 4.3 release, made available in the first quarter. This release incorporates an industry standard, TLS or Transport Layer Security, into our best method of delivery. What this means is that when our policy engine determines that an email or attachments contain sensitive information, we determine the preferred way to encrypt, and then our system uses our best method of delivery to deliver the encrypted message in the most effective, easy to use way, given the technology and the network configuration of the end user.

Now with the release of ZixGateway 4.3, we first see if it's possible to deliver using ZixGateway-to-Gateway transparency, which occurs when both the sender and the receivers are Zix customers. This is by far the safest and easiest method of delivering encrypted mail and ensuring a broad range of options for the receiver and ensuring that all replies are encrypted as well. If ZixGateway-to-Gateway is not option, our best method of delivery then will determine if a transparent TLS delivery mechanism has been enabled and if the setup of that connection satisfies the security policies of the senders. If the answer is yes, then we'll deliver the message transparently using TLS.

Prior to ZixGateway 4.3, 30% of our recipients were receiving their mail transparently without any registration or password required. Now, augmenting this with TLS, where possible, should help to expand upon the percentage of the recipients receiving transparently, and because of the tight integration we designed, we are the only solution in the industry that can provide detailed reporting for security compliance officers. This detailed reporting enables users to determine exactly if and how an encrypted message was sent, whether it was between ZixGateways, sent using TLS, ZixMail, or via the Zix portal. Reception we have seen from our prospects and industry analysts has been extremely positive, and we are excited to add this innovative offering to our list of differentiating features.

Our technology is but one view through the prism. Another view is based on industry vertical. We measure our new first year orders and our revenue in four categories: our three core verticals--Healthcare, Finance, and Government--and a fourth category we simply call Other captures the rest. The breakdown across these verticals remains similar to prior quarters, with Healthcare leading the way followed by Finance, Government and Other.

We expect Healthcare to continue to be strong source of new business in 2012. This is in part due to a far more intense enforcement environment coupled with the expected issuance of the final high tech regulations that will kick off the full version two of the HIPAA era.

The industry has been operating under an interim rule from Health and Human Services since 2009. But the widely-held belief is that we'll see the final rule in 2012. This could mean any organization that sat on their hands for years in anticipation of final language will now have to get moving.

Market data suggests that only 60% of hospitals in the United States have some form of encrypted email. So 40% of the market has yet to adopt. Of the 60% that have implemented some solution, Zix has a 40% market share, with deployments now in over 1400 hospitals. So we believe our opportunity in this segment continues to be sizable. The dominant position we've taken in healthcare serves as a great example of the power of our Zix directory, waking users and maximizing ease of use through transparency.

We are also pleased with our progress in the Financial Services vertical. In Q1 we added banks and other financial institutions to our customer base, so that now we have over 1700 Financial Services customers and are used in 18% of the banks in the United States.

In closing, I am pleased with our record results for the first quarter and am very confident in continued positive momentum as we look to the rest of the year. While the first quarter of 2012 represents growth over our 2011 first quarter, we believe we have a long way to go to reach the company's true potential for growth. We continue to focus our efforts on achieving that growth going forward. With that, I now would like to turn the call over to Mike English, our CFO, to discuss our first quarter financial results in more detail. Then we'll be happy to take your questions. Michael?

Mike English

Thanks, Rick. Good afternoon, everyone. We achieved excellent results in our key financial metrics, including revenue, net income, adjusted net income, and adjusted EBITDA in the first quarter of 2012. We reported record revenues of $10.3 million for the first quarter, which compares to $9.3 million for the first quarter of 2011. This was above the top end of our guidance range of $10 million to $10.1 million.

GAAP net income was $2.4 million, essentially flat with the same quarter last year. On an adjusted basis, non-GAAP net income for Q1 2012 was $2.9 million, compared to $2.5 million for the same period last year. First quarter revenue grew $1 million in increase, an 11% increase over the comparable 2011 figure. Our OEM partners drove approximately $340,000 of the revenue increase for the quarter, a 34% improvement from the first quarter a year ago. Our direct sales to enterprise and corporate customers, including through our re-sellers and managed security service providers, drove the remaining growth.

We ended the first quarter with bookings backlog of $52.3 million, which is a 5% increase over the $49.7 million backlog at the end of the first quarter 2011, and 3% below the Q4 2011 ending backlog. Although our subscription model generally delivers sequential quarterly increases in our backlog, we do from time to time see minor dips due to normal timing of renewal orders and the amortization of scheduled revenue on existing contracts. The first quarter was one such case. We anticipate approximately 58% of the backlog will be recognized into revenue in the next 12 months.

Let's move on to look at our various margins, as well as the details in our expenses. We achieved first quarter adjusted gross profit of $8.5 million, 82% of revenues. This compares to $7.5 million, 81% of revenues for the same quarter in 2011. On a sequential basis, it compares to $8.1 million, or 82% of revenues for the fourth quarter of 2011.

Adjusted R&D expenses were $1.5 million in the first quarter of 2012, compared to $1.3 million in the first quarter of 2011. Adjusted SG&A expenses for the first quarter were $4 million, compared to $3.7 million for the first quarter of 2011.

Adjusted operating margin for the first quarter was $3 million, 29% of revenues, compared to $2.5 million, or 27% of revenues for the first quarter of 2011. Our adjusted EBITDA for the quarter was $3.3 million, compared to $2.9 million in the first quarter of 2011. The adjusted EBITDA margin percent for the first quarter was 32.4%. Capital expenditures for the first quarter were $228,000, and depreciation expense was approximately $333,000. Approximately 71% of depreciation expense was recorded in cost of revenues.

We ended the quarter with $18 million in cash, a sequential decrease of $2.7 million. The net decrease was driven by a $5 million repurchase of our common stock, which resulted in the repurchase of 1.7 million shares at an average price of $2.97. This repurchase was part of the $15 million share repurchase program announced in November 2011. At the end of 2010 there were 67.2 million shares outstanding, and by March 31, 2012, that number had declined to 62.1 million, in large part due to share repurchases.

Operating cash flow for the quarter was $2.5 million, down from $3.4 million in the same period last year. The year-over-year decline resulted primarily from the normal timing of cash collections from our customers. Adjusted net income for the first quarter was $2.9 million, which compares with $2.5 million for the same period in 2011. Our adjusted net income for fully diluted share of common stock for the quarter was $0.04 versus $0.04 from the same period in 2011. As Rick noted, because earnings per fully diluted share is expressed by rounding to the nearest penny, the actual year over year share increase of 25% is masked by the rounding.

Now let's move on to guidance for 2012. For the second quarter of 2012, we project our fully diluted non-GAAP adjusted earnings per share to be $0.04. Our projected revenue guidance ranging from $10.3 million to $10.5 million. For the full year, we reaffirm our revenue guidance of $41 million to $43 million, and fully diluted non-GAAP adjusted earnings per share of $0.19 to $0.20.

In closing we are pleased with our first quarter results and look forward to continued strong performance throughout 2012. With that I'll turn it back to Rick.

Rick Spurr

Thank you, Michael. So let's turn it over to questions from the audience.

Question-and-Answer Session

Operator

Yes, sir. (Operator instructions.) Our first question comes from the line of Mike Malouf with Craig-Hallum. Go ahead.

Mike Malouf - Craig-Hallum

Hi, gentlemen. Thanks for taking my call.

Rick Spurr and Michael English

Hey, Mike.

Mike Malouf - Craig-Hallum

A question on the new 4.3 release. We talked a little bit about this last quarter and you alluded to the increase in transparency. I'm just wondering if you guys are thinking about doing a little bit more study on the transparency increase by implementing TLS. And if so, are you going to put out a white paper and incorporate that into some of the marketing that you're doing? I can imagine that it would be a big help for the larger account.

Rick Spurr

That's really great, Mike. It's a great question. We have built metrics or measurement techniques in our software, which tell us, as I shared, that 30% of our recipients today, prior to the implementation of TLS, receive messages transparently. We are now instrumenting a system to measure the increase in the percentage of transparency as a result of the implementation of ZixGateway 4.3. So that information will become available over the course of time.

The tricky part of this is that TLS is something that customers choose to implement, and it's a function of how many direct links they implement. These are all point-to-point links with their major partners. So we have no way of knowing how many of those are out there. We can, in a given instance with a given message, test for the existence of one of those links between sender and receiver, and we can then capture the fact that that was sent transparently, and as you suggest, measure it over time. We also are, as part of our R&D investment in 2012, creating detailed reporting that will be visible to the customers so that they will be able to see exactly what percentage of their outbound mail is being sent transparently.

Mike Malouf - Craig-Hallum

Okay. Good. That's helpful. I'll look forward to seeing that.

Rick Spurr

I'm sorry I can't give you the exact timing, but hopefully as we go through the course of 2012 we'll have better statistics.

Mike Malouf - Craig-Hallum

Okay. Great. And then with regard to new first year orders, I know you talked about the strength on the OEM side with Google and Symantec being very strong. It looks like on the corporate side they put in a pretty decent quarter. I'm just wondering if you could give a little bit more color on the direct sales side. Are they running into any significant competition there? Or really we just slipped from the first quarter into the second quarter? Typically if it's a large account, you might announce a large account, and I'm just wondering have you announced that large account that's signed yet? Thanks.

Rick Spurr

No, let me comment on this announcement thing. There's, I think, a wide misunderstanding of our business volumes and how that relates to press releases and announcements. In 99% of the cases, large customers will not allow you to make an announcement. I say 99%. I guess over history it's been more like 100%. There are two reasons for that, one is in the world of security you just generally don't want the bad guys to know what tools you're using, so customers don't want to step out and make that evident. But as importantly, they also all, from a legal point of view, want to distance themselves from any apparent endorsement.

So we close 250 to 300 customers a quarter, and we don't announce those because it would either delay the closing of the business altogether, or more frankly, customers just won't let us do it. So you see us getting customers who've been with us for three or four years who finally say, hey, we know this works and you guys are good guys and so we're going to go ahead and let you do an announcement. It's hard work to get one of those on the board.

Back to the more fundamental question I think you were asking Mike, just a little bit of color about the quarter. The OEM contribution was up 20% from the previous highest quarter we've ever had. So in absolute numbers it was up 20%. I mentioned that Google was up 49%; Symantec was up 115%. In the case of Symantec, that's off of a relatively small base, but in the case of Google, 49% is a very big number to us. Also masked in there is the fact that Webroot, who we talked about entering 2011 as a partner of ours, chose as they closed out last year to go in a different direction and not resell email encryption, so it's not like they went with a competitor or anything, they just went back to their roots--a more consumer-focused business.

So when you compare Webroot contribution in 2012 to 2011 it was down substantially. So that 20% growth had to cover up for the loss of that one pretty significant partner, and yet at the same time cause our overall growth from that channel to increase markedly.

The corporate sales are doing well. I mentioned that enterprise sales is where we think there was (inaudible) weakness in the numbers. I attribute that to some seasonality that now looks apparent in the numbers and just some typical sales cycle issues. So large accounts, as everyone knows, everybody goes through a budgeting cycle that you're in. They prioritize their projects and they come out of the gates early in the year to go implement and execute, and at the high end it just takes longer than 90 days to get through that process, is our view.

Over the last four years, as I now look at the data, three of the four years, Q1 was our lowest quarter overall. So, it's hard to dispute now, with four years of data, that seasonality. One exception was 2010, where 2010, now in retrospect, appears to be an anomaly for a whole variety of reasons. Does that answer that question?

Mike Malouf - Craig-Hallum

Thanks for the color, guys.

Rick Spurr

All right. Thank you, Mike, for the question.

Operator

Our next question comes from the line of Ian Kell with Northland. Go ahead.

Ian Kell - Northland

Hey guys, thanks for taking the call. Nice quarter.

Rick Spurr

Thanks, Ian.

Ian Kell - Northland

Just a quick one. (Inaudible) back to Google, a 49% increase there is, obviously, pretty nice to see. Is there anything fundamental in your relationship with Google that changed during the quarter or the last two quarters to propel that?

Rick Spurr

No, nothing, to use your word, fundamental. It's just evolving and maturing, strengthening relationships. I guess, if anything, they've turned up their focus on Google Apps in a variety of different ways and we are the message encryption feature that can be sold as an upgrade to Google Apps. So, I think if there's any one thing, it's just their more intense focus on the Google Apps space and that's where we're featured.

Ian Kell - Northland

Okay. On the deals that slipped out, [for] Q2 on the enterprise side, I assume these are the only things you could get closed here in Q2, or is that a longer-term thing than this quarter?

Rick Spurr

Yes, I was careful with the wording. One of them is already closed, so we can talk about that. The others, as I said, are active. You can never predict when something is going to close. Certainly, the sales guys think they're going to close, but it's never over until it's over.

Ian Kell - Northland

And I think you said that you eliminated the competition on those, anyway. Is that--?

Rick Spurr

Yes, meaning that they're at the stage now where it appears to be process and buttoning up the contractual issues as opposed to still battling with competition. Now that's not to say competition can't sneak in at the end, and you get beat up on price. That's just the nature of sales. But, for the most part, we're toward the end of those sales cycles. I can't commit to one or more (inaudible). I don't know. But then we have others, of course, that have entered the second quarter that weren't part of the first quarter. So you've got a lot moving parts.

Ian Kell - Northland

Okay. Fair enough.

Rick Spurr

But we still hit it, and I tried to project that in my remarks as it relates to demand and the pipeline.

Ian Kell - Northland

All right, good. Just on the litigation here, I'm sure you can't say much about it, do you have any insight into what the charge might be if you do?

Rick Spurr

I'm sorry, what the what might be?

Ian Kell - Northland

Just the cost related to that. I think you took $150,000 here in Q1. Do you expect it at that same level throughout the rest of the year here?

Michael English

Yes. Hey, it's Mike. You're right, it was $158,000 in the first quarter and we're going to continue to track that in the non-GAAP reconciliation where you saw that. I would expect that it will not be less. It will probably go up some, although I don't know exactly because timing of courts and what judges do with court dates and discovery, etc. is hard for me to predict. But at this point, first quarter is probably pretty good evidence of what we think it might be.

Ian Kell - Northland

Okay, thanks, guys. Thanks for your time.

Rick Spurr

On the legal issue related point to the RPost, one development is that as part of the normal pre-trial process, we have agreed on a mediator to attempt court-ordered mediation, so that's public information and something we'd want to share.

Operator

(Operator instructions)

Rick Spurr

Okay, those were great questions. We're glad to be able to add a little color and elaborate. Thank you for joining us, and we look forward to reporting on our Q2 results.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. That does conclude the presentation. You may disconnect. Have a wonderful day.

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