Tumbleweed Communications Q4 2007 Earnings Call Transcript

Tumbleweed Communications Corp. (TMWD)

Q4 2007 Earnings Call

February 5, 2008 5:00 pm ET

Executives

Scott Wilson -

James P. Scullion – Chairman of the Board & Chief Executive Officer

Timothy G. Conley – Chief Financial Officer President & Senior Vice President, Finance

Analysts

Sean Jackson – Avondale Partners

Josh Jabs - Roth Capital Partners

Brian Freed - Morgan Keegan and Co.

Allen Weinfeld - Henley & Company

Presentation

Operator

Good afternoon ladies and gentlemen, thank you for standing by. Welcome to the Tumbleweed Communications fourth quarter 2007 earnings announcement conference call. During today’s presentation all parties will be in a listen-only mode. Following the presentation the conference will be open for questions. (Operator Instructions) This conference is being recorded today Tuesday, February 5, 2008. I would now like to turn the call over to Scott Wilson, please go ahead sir.

Scott Wilson

Good afternoon, this is Scott Wilson for Tumbleweed Communications. Joining me here at Redwood City are Jim Scullion, Chief Executive Officer and Tim Conley, Chief Financial Officer. Before we begin I would like to remind everyone that today’s call including the question and answer session includes forward-looking statements regarding expected revenue and earnings per share, and future plans, opportunities and expectations of the company. These predictions, estimates and other forward-looking statements involve known and unknown risks and uncertainties that may cause actual results to differ materially from those expressed or implied in the call. These risks are detailed in today’s press release as well as in our quarterly and annual reports filed with the SEC which you are encouraged to review. The statements included in this conference call are based upon information known to Tumbleweed as of the date of this call and Tumbleweed assumes no obligation to update this information contained in this call. In addition I would like to point out that we will present certain non-GAAP information on this call phrased in the reconciliation of GAAP to non-GAAP information included in today’s press release which is also available on the investor relations section of the Tumbleweed website.

We’ll start today with Tim detailing the company’s financial results and guidance. Jim will follow that with his comments on the company’s business strategy and outlook. After that we’ll open it up to your questions. With that I will turn it over to Tim.

Timothy G. Conley

Let me review our fourth quarter results and provide projections for the first quarter of 2008. Revenue for the fourth quarter was $14.3 million compared to $16.7 million a year ago and at the upper end of our guidance range of $13 million to $14.5 million. The decrease from last year was primarily due to lower product revenue from our Validation Authority offering, a product historically sold to Department of Defense agencies. We experienced an unexpected change in spending priorities for this product within these agencies in the latter half of 2007. Accordingly, our Validation Authority product continued to contribute to our results but at a significantly lower level than a year ago. Specifically revenue from this product was $2.3 million in the fourth quarter of 2007 or 16% of total revenue a decrease from $6.5 million or 39% of total revenue a year ago.

Our core managed file transfer and email security business however remain strong and growing. We saw 21% revenue growth for these products in Q4. In the fourth quarter product revenue of $6 million was down from $8.7 million a year ago. Again this was primarily due to the lower level of revenue contribution from our Validation Authority business. Service revenue continues to grow reaching $8.3 million in the fourth quarter a 9% increase from $7.6 million in the fourth quarter of 2006 and reflecting continued growth of customers under contracts for support and threat protection services. Service revenue was comprised of $7.1 million from support and threat protection services and $1.2 million from professional services. This compares to $6.8 million and $800,000 respectively in the fourth quarter of 2006.

Gross margin in the fourth quarter of 2007 was 76% as compared to 82% in the fourth quarter a year ago excluding the amortization of intangible assets and an inventory adjustment in 2006. There are three main reasons for the decrease to 76% in the recent quarter. First, a greater portion of our business was appliance based. In fact in the fourth quarter of 2007 54% of our non-renewal bookings included appliances as compared to 28% in the fourth quarter of 2006. Second more business is being delivered through our channel partners and third we experienced a lower level of Validation Authority business which is primarily a software delivered product. The cost to provide support and threat protection services was approximately $900,000 and the cost of professional services was approximately $1 million in the fourth quarter

Operating expenses were $12.1 million in the fourth quarter or 9% less than the $13.4 million in the fourth quarter a year ago. Fourth quarter operating expenses were also 6% lower than in the preceding third quarter largely due to our expense reduction actions. We will realize further benefit of the expense reduction actions in the first quarter. These amounts are exclusive of the amortization of intangible assets, stock based compensation, and an expense of $930,000 or $0.02 a share related to cost reductions in the fourth quarter of 2007.

Our non-GAAP loss was $1.7 million or -$0.04 per share compared to a non-GAAP loss of $242,000 or $0.00 per share in the fourth quarter of 2006. These results include the $930,000 or $0.02 per share of restructuring expense in the fourth quarter of 2007. On a GAAP basis, the net loss in the fourth quarter was $3.1 million or -$0.06 per share compared to a loss of $1.5 million or -$0.03 per share in the fourth quarter a year ago. GAAP results for the fourth quarter of 2007 include $1.2 million in combined expense for stock based compensation and the amortization of intangible assets compared with $1.3 million in the fourth quarter a year ago.

Our cash position was $26.3 million at December 31^st as compared to $27 million at September 30^th and more than $1 million better than the $25 million projected on our prior call. Deferred revenue increased by $1.7 million in the fourth quarter due to strong bookings quarter to end the year at $26.4 million.

Before providing guidance for the first quarter let me give you a prospective on our directional goals for the year with respect to revenue growth and expansion of operating margins. Although not providing annual guidance we would like to provide investors with our thoughts on the direction of the business. In prior calls we have talked about the transformation in our business and the related investments and changes that were necessary to position us to maximize long term growth and profitability. Although we will continue this transformation our emphasis in 2008 is to achieve a return on those investments as demonstrated by revenue growth and improved operating margins particularly in the second half of 2008 and beyond. Further we expect to meaningfully drive down our cost of selling and engineering as a percentage of revenue during the year. We also believe the investments we’re making will allow us to deliver higher growth rates in our core business with our overall business growing at 20+% as we come out of 2008.

I would now like to provide our guidance for the first quarter of 2008. We currently estimate that revenue in the first quarter will be between $13 million and $14.5 million. Gross margins are projected to be approximately 76% to 77%. We currently expect our non-GAAP results for the first quarter to range from a loss of -$0.01 to -$0.03 per share. With a combined expense of approximately $1.6 million for stock based compensation expense, and the amortization of intangible assets we are projecting GAAP results to range from a loss of -$0.04 to -$0.06 per share. Per share calculations are based on 51.2 million shares outstanding. Further we expect to be roughly cash neutral for the first quarter.

In summary we remain confident about the performance of our core business in managed file transfer and email securities. We are committed to increasing shareholder value through top line growth and prudent expense management both of which are expected to contribute to improved non-GAAP results as we move through 2008 and into 2009. We believe the strategic steps and investments made in 2007 were the right ones and have positioned us to accomplish our goals. With that I’ll turn it over to Jim for his remarks.

James P. Scallion

Good afternoon everyone and thank you for joining us. 2007 was a year of transformation for Tumbleweed, at the start of the year we took a very critical look at our company, our place in the market and our growth prospects if we maintained the status quo. We determined that in order to lead in our target markets we needed to transform the company. As I’ve discussed during pervious conference calls, we set the company on a new strategic path. We’ve refined our product strategy, expanded our indirect sales model and implemented operational changes throughout the company. A transformation like this is inevitably painful and there were significant challenges in 2007. But there were also great strides forward and as a result we are well positioned to drive solid growth and improved operating performance in 2008

I’d like to take you through the changes we’re making and the positive results we are already seeing. First our product strategy. We generate revenue from multiple product lines as well as occasional IP licensing deals. In 2007 we continue to see demands for all our products, MailGate and SecureMessenger for email security, SecureTransport for managed file transfer and Validation Authority for identity validation. Strategically we could have gone on focusing on all three product lines but we were seeing changes in the marketplace. We saw opportunities for better long term growth if we focused on managed file transfer and email security. Business collaboration over the Internet is increasingly important for our customers and more exchanges are being done online through email, file transfers or a combination of both. With the rise in data breaches and growing regulatory and compliance pressures enterprises and government agencies need vendors with whom they can partner. Vendors who will provide holistic comprehensive solutions that enable these customers to collaborate over the Internet with confidence.

Accordingly, in 2007 our strategic focus shifted to collaborative communication solutions that leverage our managed file transfer and secure email technology. This focus on our core products has begun to yield results. We experienced near record bookings in Q4 and we saw revenue of these core products grow 21% compared to the same period in 2006. Further evidence of our position here is our recent recognition in the Leaders Quadrant of the 2007 Gartner Email Encryption Magic Quadrant. There’s still a market for identity validation and IP licensing and we’ll actively pursue both sources of revenue but these areas are opportunistic for us and as sources of revenue they are less predictable and somewhat lumpy. So while we won’t leave money on the table here our strategic focus will continue to be on our core products.

I’ll now turn to our distribution of those core products in mid-2007 under new sales leadership we more aggressively shifted to a channel or indirect distribution model. Longer term this move will allow us to both decrease our cost of selling as a percentage of revenue and increase the size of our addressable markets. And we’re already seeing the positive results in this area. Tumbleweed’s channel program delivered 37% of non-renewal commercial bookings for the full year 2007 compared to 19% in 2006. We gained particular momentum in the second half of the year following the relaunch of the Tumbleweed Alliance Program in July. Following this relaunch partner bookings doubled from Q3 to Q4 and 48% of non-renewal commercial bookings in Q4 went through the channel compared to 26% during the same period in 2006. Further reinforcing our channel strategy we saw greater demand for security products in small and mid-sized enterprises. In these markets segment we saw a 31% increase in bookings over 2006. We believe that growth in these segments will continue as organizations mature and as regulatory pressures continue to move down market.

Finally in 2007 we invested in a foundation that will fuel improved operational efficiency and growth in 2008 and beyond. We have assembled an exceptionally strong management team. In particular adding new leadership in our sales and engineering organizations. We’ve implemented a new streamlined approach to product development with the goal of delivering better products faster and we’ve progressed in moving the entire organization to a channel focus. We’ve made considerable investments during the past year and have additionally made some painful cost reductions. Combined these investments and cost reductions will help us address evolving market requirements while driving improved operating performance. As we exit 2008 I am confident that we will see the cost of selling and engineering as a percentage of revenue decline appreciably resulting from the ground work laid in 2007. All things considered it was a very productive yet challenging year for the company and we are well positioned for 2008.

While 2007 was about transformation 2008 is about execution executing on our vision, our product offerings and our distribution strategy. In the upcoming year we expect that collaborative business communications will become an increasingly strategic element of the enterprise IP strategy. In addition to large enterprises small and mid-size enterprises are beginning to adopt corporate wide communication policies. And we expect our addressable customer base to grow as business requirements for strategic content delivery solutions become more pervasive. In light of the trends we see we’ll continue to focus on secure comprehensive collaboration solutions with managed file transfer and email as our core technologies.

We see enterprise communications continuing to evolve with decreased focus on point solutions and greater interest in comprehensive collaboration offers. Multipurpose solutions that ensure enterprises can safely exchange information online regardless of file size, communication challenge or existing infrastructure. The importance of collaboration not just communication method is driving our product strategy and future offerings. We will leverage our industry leading technology and expertise to develop scalable solutions that work in unison and seamlessly integrated to existing environment. We will create these products more rapidly and cost effectively through our recently implemented streamline development processes and we will continue to offer products like Validation Authority which although not part of our core business continued to be an excellent source of revenue and another example of our technical expertise.

We remain committed to continuing our transformation to an exclusively indirect sales model. We will continue to recruit strategic high growth partners and aggressively onboard them to make them productive as quickly as possible. We built a strong foundation that will help us execute our 2008 strategic plan. We will closely manage all internal groups to ensure the plan objectives and milestones are met on time, on budget with the level of quality the industry expects from Tumbleweed and the quality we expect of ourselves. I believe that the investments we’ve made and the changes we’ve implemented will drive improvements in both top and bottom line results.

Finally I believe the upcoming year will be an excellent time for the company and I’ll look forward to updating you on our progress in the upcoming quarters. I will now ask the operator to open it up for questions.

Operator

We will now begin the question and answer session. (Operator Instructions)

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Sean Jackson with Avondale Partners. Please go ahead.

Sean Jackson – Avondale Partners

Tim, could you go and explain the expense in the restructuring costs again in the context of are you going to have more restructuring costs in the first quarter or are you finished?

Timothy G. Conley

Sean, we have taken the actions the benefit of those will be realized or a portion that was realized in Q4 and the remainder in Q1.

Sean Jackson – Avondale Partners

So you expect then some of the expense items to go down in Q1 versus the fourth quarter?

Timothy G. Conley

Yes. We do have that and you have to keep in mind to that Q1 has seasonally the reset for things like they payroll taxes and also Q4 has the benefit of more vacation being taken than in other quarters. But to answer your question, yes.

Sean Jackson – Avondale Partners

Which of those expense items did you guys cut the most?

Timothy G. Conley

By functional area?

Sean Jackson – Avondale Partners

It says the Marketing, G&A, R&D - Those segments.

Timothy P. Conley

I would say we looked at all of the organizations but primarily in development and sales and marketing would have the greatest impact.

Sean Jackson – Avondale Partners

On the product front you mentioned in the past about delivering a solution that combines the email security with the managed file transfer into one solution. How is that going?

James P. Scullion

We are building a solid business collaboration platform and we look to launch a couple of offerings this year. So things are moving forward very well.

Sean Jackson – Avondale Partners

Do you expect that by the second quarter or is it going to trickle into the second half of 08?

James P. Scullion

We see these releases basically launched in second half so we’re not giving exact dates but we look for generation of revenue on the second half of the year for any releases associated with this platform.

Sean Jackson – Avondale Partners

Now that you’re putting more of your products through the channel has it changed any of the competitive dynamics? Are there different competitors that you’re seeing now trying to compete with the channel’s attention?

James P. Scullion

Well we’re seeing more opportunities and our pipeline is growing. So therefore we’re seeing probably some more competitive deals out there. But with the managed file transfer and where we’re going with business collaborative communications we’re actually in the forefront there in building a channel and we’re seeing less competition than the email security marketplace. So it’s really a differentiator for our channel partners and our strategic partners and we’re seeing good strong adaption of our products by their customer base and quite frankly the email security space, the inbound threat side is very crowded and competitive and it hasn’t changed over the last year but we do see more and more of let’s call it IronPort and Cisco in those competitive bakeoffs but again our product family is going to be differentiated more and more as we provide a broader communication platform than anyone else in the market we compete against today.

Sean Jackson – Avondale Partners

So it sounds like the strength that you had in bookings perhaps is more weighted toward the managed file transfer versus the email, is that fair?

James P. Scullion

We actually saw strength in both. Good progress both in email and managed file transfer.

Managed file transfer had a little bit higher growth rate but email did quite well.

Operator

Our next question comes from the line of Josh Jabs with Roth Capital Partners. Please go ahead.

Josh Jabs - Roth Capital Partners

Maybe digging a little bit more into the competitive environment you mentioned maybe a little bit of a shift in focus of the small to mid-markets. Once again it’s traditionally been more of a Cisco, PostEx, Postini type area. Have you also looked at those organizations having a tendency to look more for outsource solutions, service platforms and any plans for those type of offerings?

James P. Scullion

No. Our offerings today as you know are on premise and we continue to do well in the enterprise space as well not just the mid-tier and S&B market. We moved down market because of our appliances and our ability to add channel partners to the distribution model. So we continue to sell into the enterprise space. We do compete against Cisco and secure at that level and down in the markets we talked about the mid-tier and the S&B we’re seeing a few more players. But it’s a broader market that we’re addressing by going down into the mid-tier and the S&B but we’re still focused on the enterprise and we’re going stay on premise at least through 2008 with all our offerings.

Josh Jabs - Roth Capital Partners

Going back to the restructuring expenses. I guess what we’re looking at here is there any reason that we shouldn’t be excluding that from the pro forma numbers? It didn’t look you had done that today.

Timothy G. Conley

Josh, that’s a good point. We wanted to list it separately which we have on the P&L so that people could specifically identify it and typically we’ve only had the stock comp and amortization of intangibles as the deltas between GAAP and non-GAAP so we preserve that. But certainly from a kind of modeling the business on an ongoing basis you would carve that out and treat it separately.

Josh Jabs - Roth Capital Partners

And excluding taxes that was a $0.02 – If you look at the impact of the taxes it was essentially a $0.02 hit to the bottom line?

Timothy G. Conley

It was $0.02 hit for the restructuring yes and then $0.02 on an ongoing.

Josh Jabs - Roth Capital Partners

DSOs jumped a bit in the quarter. Can you talk about that a little bit?

Timothy G. Conley

Actually we had a very good quarter on collections we had built up in the deferred revenue so that doesn’t enter into the recognized revenue computation so we have that and those billings though in receivables but not entering into the recognized revenue calculation.

Josh Jabs - Roth Capital Partners

Last one. Obviously another tough day in the markets. Can you talk to your exposure to the financial services market both in the renewal business and also the pipeline of activity at least the first half of this year?

James P. Scullion

That’s still, Josh, a very important market for us, so there is risk there. It represents high 20s, 30% of our business historically. We have expanded to other verticals through our channel partners so we’re trying to obviously expand our vertical market reach and our geographic reach, but we’re watching that market very closely like everyone is and we’re not seeing any signs yet of business going away and certainly not in renewals. Our renewal rates are strong and so far we haven’t seen any impact to our Q1 opportunities or our Q2 opportunities.

Operator

(Operator Instructions)

We have a follow up question from Josh Jabs. Please go ahead.

Josh Jabs - Roth Capital Partners

You talked about some, not guidance, but maybe goals for 2008 as far as the growth actually in the year 20% type growth number. Can you talk about how you expect that to transition throughout 2008? I guess in the back half. Where does that growth pick up?

Timothy G. Conley

Just to be clear, Josh, the 20% is really talking about as we move out of 2008 to be able to accomplish a 20% growth rate. As we move through the year though I would expect that the first half of the year will be, given the guidance for Q1, maybe a slight uptick in Q2 and then more of the growth in the back half of the year. We’re not projecting a 20% growth for 2008.

Josh Jabs - Roth Capital Partners

Maybe we can blend that into Q4 into 2009?

Timothy G. Conley

Yes.

Josh Jabs - Roth Capital Partners

On the cost savings. Is that - I guess maybe this was answered, We’ll see the results in Q1 and then is that it? Are there any ongoing initiatives there to reduce expenses?

Jim, I think you mentioned expecting some improvements here in 2008. [Inaudible ] what you guys are doing there?

James P. Scullion

We’re always evaluating where we can cost save and we continue to do that and you’ll see us do that throughout 2008.

Operator

Our next questions comes from the line of Allen Weinfeld with Henley & Company. Please go ahead.

Allen Weinfeld - Henley & Company

What do you think will be the time where we see the break-even or the line will be switched to the profitability? Do you think it can be June after we have the - You said at least 10% expense reduction in the first quarter if we do the range of revenue or as we did this quarter the higher end of the range. We can go make say 15 million in June with the shares staying the same and they gross margins staying the same. Is that where we can turn the corner to say $0.00 and then the back half start have the machine really rolling?

Timothy G. Conley

Allen, a couple of points there. Just to be clear on the 10% cost reductions is not a 10% from Q4 to Q3. It was for actions taken even prior to that. So we realized some of that benefit in Q4 already and then the balance in Q1 so just to be clear on that. I think that we’re just giving guidance for one quarter but certainly is our expectation to achieve non-GAAP profitability for the year and say in the first half to be roughly about cash neutral and improve each quarter as we move through the year.

Allen Weinfeld - Henley & Company

I know this is taboo but I actually have a company of the same marketing capsize with the stock in the same kind of place, announced really small stock buyback with actually less cash than you and it really got the stock moving. I’m talking a really small cash buyback because they had the cash and investors just were enthusiastic about it. I know you never want to go below 25 but now that you see that you might get back to generating cash in the end of the year is there anything that’ll change your thinking considering you’ll definitely be profitable. Anything that would change your thinking to just thinking how cheap it could be and how -

Timothy G. Conley

Good point. We have evaluated that in the past and will continue to evaluate in the future depending on the situation so we’re not predisposed either direction.

Allen Weinfeld - Henley & Company

And the 78 versus the 76. Is that the more appliances through the channel, the more the margin goes towards 76, 75? Is that how we should look at it?

Timothy G. Conley

I’d say yes. One of the biggest components is the amount of business that is going through channel which is largely on an appliance base but we think that mid-70’s is a reasonable rate for our gross margins.

Allen Weinfeld - Henley & Company

Can you say anything about the international? I know you just spent some money there, definitely opened up some resellers, got some offices going. What percent of your 2007 revenue or your fourth quarter revenue was from outside the United States?

James P. Scullion

We said in our presentation 14% in Q4.

Allen Weinfeld - Henley & Company

Do you expect that to grow?

James P. Scullion

Our goal is to grow that considerably over the next two years and continue to grow it. We want to be in the 20+% percentage range certainly within 18 months or ultimately be at 30+% so we’re continuing. We’ve got a really good teams in Asia Pac and in Europe. They’re staffed and we’ve developed really solid channel partner relationships and we continue to build there with channel partners. The teams are pretty well in place and we’re looking to expand and grow the revenues there.

Allen Weinfeld - Henley & Company

Is there any differentiation in competition? Because if you talk to your average competitor Secure Computing, CipherTrust or Ironport with Cisco, the guys that are not the Postini in the air but the guys that are on the ground and they swear they don’t see you unless they are trying to rip you out. They don’t see you in new business opportunities and that just can’t be the way it is. Any change in the competitive environment? Is it tougher? Is it easier? Your channel partners it helps you a lot more or what do you see?

James P. Scullion

The email threat protection marketplace, inbound threat protection is competitive in all aspects, be it North America or internationally. We’re seeing really good progress in both marketplaces with our core products, but we’re also seeing even a stronger market opportunity for our managed file transfer products internationally.

James P. Scullion

In fact there is almost no competition for that but please do see how important the Ironport CipherTrust [inaudible] most of the engagement in the US.

Timothy G. Conley

I would say we see Ironport. Cisco and we see them in the international markets a lot in Asia Pacific and obviously in North America. So they’re out there. Again, we grew nicely in our core products in Q4, we grew in our email, we grew in our managed file transfer. Both grew solid double digits and overall it was 21% and we’re getting traction through the channel and I think that strategy is starting to be fruitful and we’re seeing - We’re in a lot more deals now than we used to be. Our contract size is up, our volume is up.

Operator

(Operator Instructions)

We have a follow up question from Sean Jackson with Avondale Partners. Please go ahead.

Sean Jackson – Avondale Partners

Can you talk about the expectations for the Validation segment? Obviously it’s coming off a rough year. Is there any inkling of hope there that there could be some bounce back or do you expect further deterioration?

Timothy G. Conley

We actually think that’s a solid product line. There’s still solid market opportunities for the product in the Federal marketplace. We don’t what the buying trends will be by DOD customers. We’re expanding into the civilian side of the Federal marketplace and it’s such a mature stable and scalable product line that I think there will always be opportunity for us to sell that product and we support it and our customers are happy with the product. Right now we’re being cautious on projecting any revenue growth in our internal numbers and our quarterly guidance to you.

Sean Jackson – Avondale Partners

Lastly, on the overall business. Do you have any metrics as far as new customers in the fourth quarter gained versus previous quarters?

Timothy G. Conley

Sean, I think the gain was roughly comparable to prior quarters. We have over 3,200 customers active currently.

Sean Jackson – Avondale Partners

So the brand new ones are pretty similar to other quarters?

Timothy G. Conley

Yeah.

Operator

There are no further questions at this time. I would like to turn the call back over to Jim Scullion. Please go ahead sir.

James P. Scullion

Thank you for joining us today we absolutely look forward to giving you progress reports each quarter throughout 2008. We look forward to giving you our Q1 results here following sometime in late April, maybe early May. Appreciate all your support. Thank you. Look forward to speaking to you soon.

Operator

Ladies and gentlemen this concludes the Tumbleweed Communication’s fourth quarter 2007 earnings announcement conference call. If you’d like to listen to a replay of today’s conference please dial 303-590-3000 or 800-405-2236 and enter passcode 11106213. ACT would like to thank you for your participation. You may now disconnect.

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