S1 Corporation Q1 2008 Earnings Call Transcript

S1 Corporation (SONE)

Q1 2008 Earnings Call

May 2, 2008 8:00 am ET

Executives

John A. Stone – Chief Financial Officer

Johann J. Dreyer – President, Chief Executive Officer

Analysts

John Kraft - D. A. Davidson & Co.

Martin Schutz - HIRG

Presentation

Operator

Welcome to the S1 Corporation first quarter 2008 earnings call. (Operator Instructions) And I'd now like to turn the conference over to Mr. John Stone, Chief Financial Officer.

John A. Stone

I'd like to remind you that we will be making forward-looking statements on today's call. These forward-looking statements are based on our current expectations and are subject to a number of uncertainties and risks. Actual results may differ materially. Please refer to the risk factors identified in our Form 10-K for the period ended December 31, 2007 and subsequent filings with the Securities and Exchange Commission.

I'm here today with Johann Dreyer, our Chief Executive Officer, but before I hand the call over to Johann, I'd like to make some comments about our results for the first quarter of 2008.

As the press release indicates, our total revenue increased 15% to $54.7 million during the first quarter of 2008, with a 62% increase in license revenue to $9.3 million, which is primarily due to increased demand for our Postilion payment solutions.

Support and maintenance increased $1.2 million or 12%. Professional services increased $1.6 million or 8% due to increased activity related to Enterprise's treasury online solutions, Postilion's payment solutions globally, and Enterprise international customers, partially offset by a decline in State Farm revenue. Data center revenue increased $600,000 or 5% due to growth in the Enterprise business.

First quarter 2008 license revenue included $2.6 million of subscription revenue by comparison to $1.9 million in the first quarter of 2007, and this increase is primarily attributable to demand for our Postilion banking solutions in the U.S. community and regional market.

State Farm revenue decreased $1.7 million from $12.3 million in 2007 first quarter to $10.6 million in the first quarter of 2008. I'd like to emphasize that all the growth we are achieving in revenue, all this growth is organic, and there were no acquisitions in these two periods. Furthermore, excluding the State Farm relationship, revenue from all other customers increased 25% from the first quarter of 2007 compared with the first quarter of 2008.

Gross profit margins improved to 54% in the first quarter of 2008 from 52% in the first quarter of 2007, and adjusted EBITDA as a percentage of revenue increased to 20% in the first quarter of 2008 from 16% in the first quarter of 2007.

Direct costs associated with professional services support and maintenance increased $1.5 million in the first quarter of 2008 compared with the prior year quarter, in line with growth in professional services projects and to provide additional customer support.

Data center costs increased as well by $800,000 mainly for the Enterprise segment, which is in line with their growth in data center revenue. Sales and marketing costs increased in line with the growth in revenue.

Product development expenses increased slightly in the year-over-year comparison, and depreciation increased slightly as well. But product development expense, I'll point out, declined as a percentage of revenue from 13% in the prior year to 12% in the first quarter of 2008.

In summary, the first quarter 2008 operating income was $6 million, a $3.5 million improvement compared with the first quarter of 2007. Adjusted EBITDA increased $3.5 million as well to $10.9 million in the first quarter of 2008 compared to the same period in 2007. Those figures exclude stock-based comp expense of $1.9 million for both periods as the reconciliations and schedules at the bottoms of Tables 4, 5 and 6 indicate.

Moving on to the segment results, focusing first on Enterprise on Table 5, the Enterprise segment's total revenue increased 14% to $29.5 million for the first quarter of 2008 as compared with the first quarter 2007.

Professional services revenue increased by $1.6 million, reflecting an increased number of implementations, particularly internationally, partially offset by a decline in projects with our largest customer, State Farm. Professional services revenue and sometimes license revenue can be impacted by progress made towards completion on large system implementation projects in any one quarter and is based on estimations that can change.

Data center revenue increased $1.4 million due to an increase in transaction volumes for our existing customers. Taking into account the decline in State Farm revenues of $1.7 million, revenue from all other Enterprise customers increased nearly 40% from the first quarter of 2007 to the first quarter of 2008.

Enterprise segment improved gross profit margins from 48% to 49% in the first quarter of 2008. Enterprise generated $1.9 million in operating income in the first quarter of 2008 as compared to $1 million in the same period in 2007 as a result of increasing revenue and improving gross profit margins. Similarly, Enterprise adjusted EBITDA increased $1 million to $4.5 million in the first quarter of 2008.

Continuing now to the Postilion segment as presented on Table 6, total revenue increased 16% to $25.2 million in the first quarter of 2008. Now this included a 68% increase in license revenue when compared to the first quarter of 2007, primarily due to increased demand for our Postilion payment solutions.

There are several factors that can affect the timing and amount of license revenue recognized under GAAP in any given quarter, and we've emphasized in the past that the license revenue line can be lumpy from one quarter to another. The average transaction size for the Postilion payment solution has been rising, and increasingly contributes to this potential lumpiness.

Postilion segment software license revenue also includes subscription revenue of $2 million in the 2008 first quarter by comparison to $1.3 million in the first quarter of 2007. Now this is long-term recurring revenue being generated by the subscription model even though it is appearing in the software license revenue line, and we've described this subscription revenue on previous calls. It includes the right to use the software and receive maintenance and support and enhancements. And in some cases these subscriptions also include data center services.

The continued growth in the subscription revenue reflects the broader acceptance of the Postilion product and the subscription model in the U.S. community banking space. Over time, we anticipate that growth in subscription revenue will have a negative impact on support and maintenance revenue and data center revenue.

Postilion's support and maintenance revenue increased 13%, reflecting continued strong licensing activity in the payment space.

Postilion data center revenue is down in the first quarter of 2008 as compared with the prior year quarter, and that's partly due to the conversion of customers to long-term subscription contracts and some customer attrition in the U.S. community banking space.

Gross profit margins improved to 60% in the first quarter of 2008 from 57% in the first quarter of 2007, driven mainly by growth in perpetual license revenue in the payment space, professional services support and maintenance costs increased to accommodate the growth in professional services projects and to provide additional customer support.

Postilion operating income of $4.1 million in the first quarter of 2008 compares favorably to $1.5 million in the first quarter of 2007 as a result of increasing revenue and improving gross margins. Similarly, Postilion's adjusted EBITDA increased $2.5 million to $6.4 million in the first quarter of 2008 by comparison to 2007 first quarter.

Turning now to the balance sheet on Table 2, cash and short-term investments were up $4.3 million to $73.2 million since the end of 2007, that increase due to cash from operations of $4.8 million and we received $3.7 million from the release of funds in escrow related to the 2006 sale of our Risk and Compliance business. These increases were partially offset by capital expenditures of $2.2 million and $1.7 million of repurchases of our own common stock.

We have about $8.3 million of restructuring charges remaining to be paid after paying out approximately $900,000 in the first quarter of 2008. We expect to pay $2.7 million over the next 12 months and then approximately $2 million a year through the end of 2011.

Accounts receivable increased $4.8 million during the quarter on increased revenue, primarily due to an increase in unbilled receivables and three-quarters of which relates to professional services work for our largest customer, State Farm.

Total DSO is down to 69 days versus 92 days at the end of the first quarter of last year. DSO was 67 days at the end of last year.

Turning to income taxes, the $1.1 million of taxes in the first quarter of 2008 relates to taxes paid in international jurisdictions where we do not have NOLs, some state income taxes and alternative minimum tax in the U.S. This provision is entirely cash taxes and represents an effective tax rate of 17%, an increase over prior periods but still a manageable amount of taxes.

Although our cash taxes can vary based on the jurisdictions where we generate income or losses, we anticipate our cash taxes will remain in this range on a percentage basis throughout 2008.

As of March 31, 2008, S1 had approximately $223 million of domestic NOLs which are fully reserved. Of this amount, $201 million relates to stock option expense stock option expense, the benefit of which would go directly to stockholders equity if ever used.

So with about $22 million of domestic non-option NOLs remaining, it's possible that we may begin recording a tax provision with an effective rate of perhaps 37% or more for GAAP purposes as early as the second half of this year, even though a significant portion of these GAAP tax provisions would be non-cash through the utilization of these option-related NOLs.

If we're successful in implementing our operating plan for 2008, we will likely reach a point in the third or fourth quarter of this year when we will need to release a portion of the valuation allowance against these NOLs.

Turning for a minute to our 2008 guidance, we've increased our expectations for the full year of 2008 revenue to between $220 and $226 million from $216 to $220 million based on our current backlog and pipeline of opportunities. We've also raised our earnings guidance while focusing on adjusted EBITDA. We're expecting between $41.5 to $43.5 million of adjusted EBITDA for the 2008 full year. Adjusted EBITDA excludes stock-based compensation which, as we have discussed before, can include significant swings due to the valuation of stock appreciation rights or SARs.

For example, stock-based comp in the third quarter of 2007 was $3.1 million or roughly $0.05 per share and was only $600,000 in the 2007 fourth quarter or roughly $0.01 per share. This swing was based on the value of SARs, which under GAAP is simply a function of the closing price of our stock on the last day of the period. So that demonstrates that stock-based compensation expense can cause a significant swing in earnings from one quarter to the next that cannot be predicted and has very little direct correlation to the results of operations for the two reported periods.

If you consider our results of operations starting from the second quarter of last year to the first quarter of this year, we've generated adjusted EBITDA as a percentage of revenue quarterly in the range of 19% to 21% and our guidance suggests we'll expect to operate in that range for the remainder of this year, supporting double-digit topline growth and making some targeted investments aimed at achieving our customer satisfaction goals that Johann will describe more fully in just a minute.

So let me recap. On a consolidated basis, first quarter revenue grew 15%, 25% excluding State Farm. First quarter license revenue increased 62%, and we translated that top-line growth into growth in earnings. Net income increased 75%, GAAP earnings per share 89%, and adjusted EBITDA 48%. Almost half the increase in revenues went straight to the adjusted EBITDA line. Finally, our updated 2008 guidance shows further growth in the top line with similar earnings.

With that, I would like to hand the call over to our Chief Executive Officer, Johann Dreyer. Johann?

Johann J. Dreyer

We are very pleased with the results of the first quarter and are really looking forward to the remainder of the year. I would like to start off by reiterating some of the goals that we set ourselves on the last call for 2008, and it really was based on three items.

Firstly, we were looking at top-line growth of 6% to 8% and if we excluded our largest customer, that translates to 10% to 12% top-line organic growth. We were looking for this year at earnings growth of 15% to 25%.

And then lastly, we put a big emphasis on customer satisfaction for this year. As you can recall from the previous call, I stated that in 2007 we focused on turning the company around from a financial perspective, and this year we really want to put a lot of emphasis on customer satisfaction, really exit this year not only financially very strong but from a customer satisfaction perspective, the premiere company in our space in the industry. A quarter later, I would like to talk a little bit about our progress against those goals.

As far as the top-line growth is concerned, we have raised our guidance and we now expect our growth to be closer to double digits, right now in the order of 8% to 10% range.

And in terms of customer satisfaction, we intend to take some of that additional revenue and have embarked on a number of customer satisfaction programs in selected parts of our company to make sure that we exit this year as the premiere company in our space.

In terms of the segments, I would like to talk a little bit about the Postilion segment and then about the Enterprise segment. And I'll start off with the Postilion segment.

We've added a number of new key customers in the last quarter. We added a Top 10 retailer in the U.K., and that means that our payment solution is now used by three of the Top 10 retailers in the U.K. We are placing a lot of emphasis on that market this year and the next year, and we hope to grow further and increase and work from that solid base that we have there right now.

We also expanded our Middle Eastern footprint to a new country by signing up the second-largest bank in Qatar. Our Middle Eastern office is growing its business very rapidly, and we've made some great inroads in that part of the world over the last year to 18 months.

We also added three more banks in Africa. We're now in 15 African countries. We're growing our footprint there and, as I mentioned on the last call, even though it's off a low base that is a very fast-growing country in terms of card usage, in terms of transactions. It's really coming off a very low base, and since our product is licensed on a volume basis, any growth that we achieve obviously is very beneficial to us or any growth that those customers achieve is very beneficial to us. And we also added a credit union in the U.S. for our personal banking product.

In terms of the Postilion products, as you will recall from our prior calls, we're taking the legacy voice and Internet banking products on to Postilion, and in our last call we mentioned that we will take our first Internet banking customer into Friends and Family this quarter. We've actually achieved that, and next week we will go live with that customer.

And right now we have personal Internet banking, mobile banking, voice banking, ATM and card management all fully integrated. Of them all, all is in general acceptance or general availability except our Internet banking solution, which I mentioned is going into its first live implementation next week. And we're very, very confident about the quality of that product, how it will change the marketplace. It's a very unique product in the marketplace, and I think we are getting much closer to our goal of having an absolutely unique offering in this space in the last half of this year. Obviously, we'll have to gear up to convert our 1,000 or more customers over the next two years, and we're in that process of gearing up. But there's a lot of excitement in the company about that new product.

Moving on towards the Enterprise segment, some significant milestones, we sold our mobile application to two existing customers and are getting some real traction with that application. We also rolled out our sales and services platform to 99 branches of a German bank in Slovakia and Hungary, and also increased our presence in Thailand and are now in a very strong position with quite a few of the top banks in that country. Our strategy that we embarked on a year ago of focusing our Asia Pac operations on Thailand is really bearing fruit, and we're pretty pleased about our position there.

In closing, we're very pleased with the quarter. Our pipelines are looking very healthy, and we have very high visibility. We're excited about 2008 and we are getting very excited about 2009 as well. And we are very comfortable and confident in terms of the increased guidance that we've given to you. We feel that those numbers are very achievable, and we are really looking forward to the remainder of this year.

Thank you very much for joining the call.

Questions-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Kraft - D. A. Davidson & Co.

John Kraft - D. A. Davidson & Co.

You talked a lot about international deals. Can you break out specifically what the international contribution was in the quarter?

John A. Stone

It's growing. It's approaching 30%. I don't have the number in front of me, John, but it's contributing nicely to growth and in both segments, I might add. Enterprise and Postilion both have a healthy amount of Enterprise (sic) exposure now.

John Kraft - D. A. Davidson & Co.

And then specifically with your Enterprise, it appears at 40% ex State Farm that things are obviously going well there. Were there any deals, any bigger contracts that might have been pulled in to the quarter early that you might have expected to happen later on in the year?

John A. Stone

No. No. I would point out that a lot of that growth is being driven right now by professional services. That's part of the nature of that product. When you look at that model, it has the potential to do just about anything for a large bank, and so we do see our large bank customers spending money to enhance that and, find ways to put it into bigger parts of their company. So a lot of growth there in professional services.

We've also seen a little bit of a shift in the licensing model, where we wind up doing a significant amount of professional services before we sign a license just to help the customers prove out concepts and prove out the platform. In one particular instance, we are now seven figures into an implementation where the bank has not yet signed the license.

John A. Stone

Well speaking of the licenses, maybe a bigger picture here, if I could. The commentary that you've made here about not seeing a slowing and the pipeline growing and all that is particularly, I think, interesting given that really all your competitors have talked about licensing being really an area of weakness in this environment. Can you speak to this? Is it that your pipeline customers have been waiting so long for the S1 product that they just can't put it off any longer or is it the international aspect or why aren't you seeing softness in the licensing?

Johann J. Dreyer

John, I think there are a number of aspects here. Firstly, we do have a broad range of products. Secondly, we have a worldwide footprint and it is a fairly diversified footprint in that we sell not only to financial institutions but into other industries - retail, petroleum and telcos. We do have products out in fast-growing economies as well, and that means that we do benefit from additional licenses required by those companies as they acquire more customers or more customers use their ATMs or become Internet banking customers. So we benefit from some of the growth of our customers in some parts of the faster-growing economies in the world.

We also have come from a fairly low base in some of our product ranges. We reinvested over the past year to 18 months. We have better product available now and, coming off a low base obviously is to our benefit at this stage with a new product range.

Our products do help reduce costs at customers, so when a customer is in more of a squeeze situation they tend to turn to automate certain processes and therefore they are looking at our software. So there's a variety of reasons.

So we've seen both a very healthy pipeline and we've also seen a higher conversion rate of the deals in that pipeline. In a downturn in the economy people say don't look at the pipeline; look at how you can convert the pipeline into real business. And we've seen a growing pipeline and we've seen a higher conversion.

So, I would summarize to say a broad range of products, international footprint, diversified customer base, we come off a low base, and a pretty improved product from a year ago.

John Kraft - D. A. Davidson & Co.

You said something about average Postilion transaction size increasing. What do you mean by that?

Johann J. Dreyer

Look, basically we license our products based on the volume of business that our customers generate. In other words, let's take the case where we sell an Internet banking solution in Thailand or, anywhere in the world, in the U.S.

We license that by number of end users so if, for example, a bank has a million end users and they grow that by 10% to 1.1 million, then that means additional license fees back to us. Likewise, if a bank has 100 ATMs and they increase it to 120 ATMs, due to growth of their base that means additional license to us.

And by having some of these systems out in areas of the world where there is still transaction adoption and Internet adoption that helps us in generating additional revenue.

John A. Stone

John, if I can add, on the Postilion payments product, I think, I made a comment about average transaction size.

We haven't talked about average transaction size very much because as a company we have so many different products and they're licensed on different models, but this is a growing trend for the payments module over the last two or three years where, as Johann said, it's licensed on a volume basis. Historically, they were smaller retailers and smaller deployers, and we're seeing larger and larger organizations interested in that platform and consequently the average transaction size is growing significantly. In fact, it's not uncommon to have an initial license fee related to a payments sale that's well into the six figures.

Does that help?

John Kraft - D. A. Davidson & Co.

So transaction size meaning transaction volumes?

John A. Stone

Well, no. We want to make a distinction between growth in the installed base. Once we license the payments product, for example, it may be licensed based on the number of point of sale devices hanging on a switch, it may be licensed based on the dollar value or dollar volume of traffic crossing the switch, and that initial license fee, of course, is based on what the customer thinks they need. And what I'm saying is that over the last two or three years we're licensing it to larger and larger customers.

Add to that Johann's comments that as those customers' businesses grow, they owe us additional license. So it's two trends we're seeing. We're in areas of the world where GDP is growing very nicely, and the growth of the electronic commerce is, in some cases, outpacing the growth in GDP. So that's helping revenue grow. That answers your question how we are growing revenue in this economy.

But then I wanted to make a qualitative comment about the Postilion license revenue and the fact that larger and larger organizations are licensing that platform and that's a good thing for us.

Johann J. Dreyer

The bottom line is we're selling bigger deals to bigger customers.

John A. Stone

And then, John, I've got the international revenue. In the first quarter of last year it was about $9.6 million and the first quarter of this year it's almost $15 million. So that's healthy growth there internationally, 50% increase year-over-year. That's not quite 30% of the company, but if you stripped out State Farm, which is entirely domestic, it's a very healthy portion, I think, good exposure to international.

Operator

Your next question comes from Martin Schutz - HIRG.

Martin Schutz - HIRG

I was wondering if you might give us some more detail on who Postilion competes against, if you might speak to a two to three-year growth outlook, give us maybe a little bit more detail on some of the functionality that's available and what competitors specifically compete against different functional pieces, and if you might also differentiate penetration or growth potential in the U.S. versus overseas markets. Thank you.

Johann J. Dreyer

Okay, so the Postilion segment really sells into three spaces, as such. Firstly, there is the payments portion. Secondly, there is the self-service banking in the community financial space. And thirdly, there is our full-service banking area. Let me take each one of those in turn because they do have different competitors and they do have different models.

The payments business is a global business. The two other businesses are U.S. specific. In terms of the payments business, our largest competitor or our best-known competitor would be ACI Worldwide. So in the case of payments, we would typically sell to banks, to retailers, to telcos, to card issuers, people like American Express, etc., would be typical customers of us. So that would be the competitors in that space. That is a fairly strong international business, good U.S. footprint as well, and many of the larger license deals that you see on the Postilion side comes from that piece of the business.

The CFG or the community financial space of the Postilion brand sells mobile, Internet, voice banking and integrated ATM solutions to the community financial space, and there our competitors would be people like Digital Insight, some of the cores, [inaudible] and so forth.

And then in terms of our FSB solutions or our full-service banking division, we sell teller and branch platforms to banks in the U.S. typically through channel, through the cores, people like Fiserv ITI or Fidelity MISER or resellers of ours in that space. And there competition would be the other teleproviders, people like Argo, etc.

Martin Schutz - HIRG

And would you contrast ASPs for those three products?

John A. Stone

Average sales price, we don't talk about that.

Johann J. Dreyer

That is not public information that we give out.

John A. Stone

If we spoke in terms of that, we'd wind up either giving you an average of averages because we have so many products on different models that it would be meaningless, or we'd wind up giving you detailed information that would be anti-competitive in a sense.

Johann J. Dreyer

And we also have, since we our license model is based on the size of the usage, there's a huge discrepancy between what we charge to a small customer versus a very large customer.

The one thing that I need to mention here is our payments business, we have a typical license and maintenance model and in our full-service banking business we have a typical license and maintenance model, and in our community financial business we have predominantly a subscription model.

Operator

We have no further questions at this time.

Johann J. Dreyer

Well, thank you again everyone for joining this call. Again, very pleased with this quarter, confident about the rest of the year. As we get more visibility in 2009, we are feeling good about that as well, and we are really looking forward to the next nine months to the end 2008. Thank you very much.

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