PLATO Learning, Inc. F2Q08 (Qtr End 04/30/2008) Earnings Call Transcript

PLATO Learning, Inc. (TUTR)

F2Q08 Earnings Call

June 3, 2008 4:45 pm ET

Executives

Michael A. Morache - President and Chief Executive Officer

Robert J. Rueckl - Vice President and Chief Financial Officer

Analysts

Bob Evans - Craig-Hallum Capital

Presentation

Operator

Welcome to the PLATO Learning second quarter 2008 earnings release conference call. (Operator Instructions)

Before we begin, PLATO Learning reminds you that statements made in their press release and on this call that are not related to historical information are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These statements are based on the company’s current expectations about future events. While the company believes that the assumptions made in connection with the forward-looking statements are reasonable, they can provide no assurance that these assumptions and expectations will prove to have been correct and actual results may materially differ from these expectations.

The company’s forward-looking statements are subject to risks and uncertainties such as those described in the company’s most recent filings with the Securities and Exchange Commission including those on forms 10-K and 10-Q.

The content on this call contains time sensitive information that is accurate only as of today, June 3, 2008. PLATO Learning undertakes no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

I will now turn the call over to your host, Mike Morache, President and CEO of PLATO Learning.

Michael A. Morache

On the call with me today is Rob Rueckl, our Vice President and CFO and Vin Riera, Senior Vice President of Sales and Services.

A little more than two years ago, we began to transition PLATO Learning from a perpetual license model to a subscription based Software-as-a-Service or SaaS model. Up to this point in the transition, revenue recognition differences between these licensing models have been a headwind in our ability to report period-over-period revenue growth.

In parallel, we have been making significant investments in market-leading products that have resulted in 10 consecutive quarters of high rates of subscription order growth. Now for the first time since beginning the transition, these high rates of subscription order growth are driving total revenue growth. In the second quarter, subscription revenues grew 58% and total revenue grew 7%. Quarterly revenue growth is a significant milestone in our transition.

In addition to total revenue growth in the quarter, we achieved total order growth. Orders for subscription products remain strong growing 22% over the second quarter of 2007, and total orders grew 4%. Furthermore we achieved this growth amid concerns that factors affecting public school funding may create near-term market difficulties for companies selling into the education market. I will provide some additional perspective on this topic in my comments later in the call.

Achieving high renewal rates is critical to the success of a subscription business. We began tracking this metric in the second half of fiscal 2007, the first period in which customers using PLE, our new online management system, had an opportunity to renew their subscriptions.

In the first half of fiscal 2008, PLE customers renewed 91% of the value of their subscriptions due for renewal, a significant improvement over a 74% renewal rate in the second half of 2007. Our renewal rate experience year-to-date supports our belief that we can sustain renewal rates in excess of 90%.

As reported in our press release today, we are nearing completion of the three-year product investment road map for our SaaS strategy. During this time, we’ve launched an industry-leading web-based learning management system, refreshed substantially all of the company’s rich content library, introduced a new set of algebra courses on PLE for community colleges, created 46 full-semester courses for grades 6 through 12, added classroom assessment capabilities to drive personalized instruction, and became the first education technology provider to offer our software on one of the most popular handheld gaming devices in the U.S.

These investments will help us sustain growth well into the future. With most of the strategic investments behind us, we took actions in the quarter to moderate product investment to a level that conforms to our long-term business model. We also implemented operating efficiencies that have been enabled by the transition to the SaaS business model.

None of these changes affected our customer-facing organizations, reflecting our belief in the growth potential now available to us. Taken together these actions and the growth and subscription orders and revenues will contribute to our goal of profitability in fiscal 2009.

After covering our second quarter results in more detail, Rob will provide additional information on what these changes mean to our spending levels going forward.

Robert J. Rueckl

Total orders for the quarter were $13.1 million. As Mike said an increase of 4% over the second quarter last year and a 22% increase in orders for subscription products. Subscription orders totaled $7.2 million, as orders for products delivered on PLE more than doubled to $5.6 million. PLE is now clearly our primary subscription product platform as PLE orders generated over 75% of total subscription orders in the quarter.

Orders for perpetual licensed products remained about flat in the quarter compared to the second quarter last year at $2.4 million, reflecting a fast start in March in orders for our Achieve Now elementary reading and math programs on the Sony PlayStation portable.

Services orders declined $750,000 in the quarter due to declining orders for software maintenance on our legacy perpetual products and a smaller decline in professional services orders. In terms of large orders, we closed 15 deals over $100,000 in the second quarter this year compared to 16 in the same period last year.

Eleven of the 15 large orders in 2008 were for subscription products up from 10 in the second quarter last year. The average value of these large orders increased to $208,000 compared to $195,000 last year, reflecting greater focus by our sales organization on larger district implementations.

The growth of subscription orders continues to drive growth in deferred revenue. At the end of the quarter, total deferred revenue was $41.7 million, a 19% increase from the end of the second quarter of last year and down seasonally from $44.4 million going into this quarter on lower deferred services revenues.

Deferred subscription revenues remained flat throughout the quarter at $30 million and increased 50% compared to this time last year. Total deferred revenue is expected to increase by up to 50% by the end of fiscal 2008.

As Mike mentioned in his opening remarks, we achieved year-over-year quarterly revenue growth for the first time since launching our SaaS strategy, and in fact for the first time in more than four years since acquisition-related growth occurred in the first quarter of fiscal year 2004. Total revenue in the second quarter was $16.2 million, an increase of 7% over the second quarter of last year.

Subscription revenues in the quarter grew to $8.5 million resulting in year-over-year quarterly growth of 58%, a consecutive quarterly subscription revenue growth of 6%. Courseware subscription revenues grew at even a faster pace almost doubling over the second quarter of last year and growing 10% on a consecutive quarter basis.

Services revenues declined approximately 8% to $6.3 million on lower revenues from technical services and software maintenance, both of which are related to our perpetual license business. The total cost of revenue in the second quarter increased 5% to $9.2 million.

Lower cost of license fees on lower related revenues was offset by a $1.1 million increase in subscription cost of revenue caused by a $900,000 increase in subscription prior to amortization. The amortization increase reflects the investments made in new subscription products and enhancements since the second quarter of ‘07.

The total gross margin percentage in the second quarter improved to 43% from 42% last year on continued improvements in subscription margins. Subscription margins in the second quarter increased 13 percentage points to 43% as subscription revenues continue to grow significantly faster than subscription costs. We expect this upward trend in subscription margins to continue for the balance of the fiscal year. Services gross margins in the second quarter declined 47% from 53% last year due primarily to the decline in higher margin software maintenance revenues.

Operating expenses, excluding restructure charges, declined slightly to $11.7 million, a small increase in sales and marketing expenses was offset by lower G&A costs and smaller declines in product maintenance and development and in intangibles amortization.

During the quarter, we recorded restructuring charges of $1.6 million related to a reduction in product development resources and reductions in operations and administrative costs as we continue to capitalize on the operating efficiency of the SaaS business model. These charges consisted primarily of severance benefits paid to terminate employees. We expect to incur additional charges of up to a $0.5 million in the third quarter related to vacated facilities.

The reduction in product development resources should allow us to exit fiscal year 2008 at an annualized run rate of approximately $12 million in total capitalized and expensed development spending, compared to the second quarter 2008 annualized spending rate of $18.5 million. The reduction in operations and administrative costs is expected to result in additional annualized cost savings of between $2.5 and $3 million. All combined, these actions are expected to result in annualized savings in excess of $8.5 million relative to the second quarter of 2008.

Wrapping up our P&L results for the quarter, strong growth in subscription revenues resulted in total revenue growth of 7% and continued improvements in subscription margins. At the same time, our cost structure continues to benefit from the operating leverage in the SaaS business model.

As a result, our net loss in the second quarter, excluding restructure charges, declined to $4.8 million in 2008 or $0.20 per share compared to $5.3 million or $0.22 per share last year. On a GAAP basis, restructuring charges of $1.6 million or $0.07 per share resulted in an increase in the second quarter net loss to $6.5 million or $0.27 per share compared to $5.3 million or $0.22 per share in 2007.

Our cash balance at the end of the second quarter was approximately $13 million, down seasonally from $19 million going into the quarter. Second quarter operating cash flow was negative $2.6 million, down from $500,000 positive operating cash flow in the second quarter last year. The $3.1 million decline reflects receivables balances that were lower entering the second quarter of 2008 than they were 2007, and increasing customer requests to fund their subscriptions over time rather than making full payment at the time of order.

Free cash flow in the quarter declined $2.6 million due primarily to the decline in operating cash flow partially offset by lower capital expenditures. The end of our second quarter historically marks the low point in cash levels as we enter the primary buying season for the K-12 market. Increased order activity, coupled with lower product investment levels and other cost savings is expected to result in strong cash flow and increasing cash balances throughout the balance of the fiscal year.

This concludes my formal remarks. I’ll now turn the call over to Mike for his further comments.

Michael A. Morache

As we’ve done on prior calls, I’d like to discuss some of the key metrics we use to monitor strategic progress. Total order growth is our broadest measure of progress, and we were pleased to report order growth of 4% in the quarter. Subscription product orders continue to grow at double-digit rates. We achieved order growth in the quarter despite press reports that public school funding may create near-term difficulties.

Thus far we have not encountered measurable weakening of demand for our products. We lost one opportunity this year due to a loss of funding by a school district. However, no other customers or prospects have indicated to us that they intend to cancel their buying plans due to funding.

We have seen anecdotal evidence that some school districts are taking longer to line up their funding and to make decisions. We aligned very closely to priorities that the education community and society are very unlikely to abandon. Graduation rate improvement, credit recovery, instructing undereducated students in community colleges, increasing instructional capacity and countering pressure from virtual and charter schools. Because PLATO solutions are so closely aligned to these priorities, we believe ample demand exists for growth under any plausible funding scenario.

Indeed we have customers who have had layoffs while continuing to place new or expansion orders for PLATO products. We track several key metrics to monitor the success of PLE. During the quarter we added a total of 129 school districts and community colleges to our PLE customer base, 80 of which were existing PLATO customers that migrated all or a portion of the programs.

Since launching PLE we’ve migrated 757 of our 4,000 customers. But keep in mind that a complete set of products to replace our legacy products have been available only for about one year. 49 new customers were added as subscribers to PLE in the quarter. Since launching PLE we’ve acquired a total of 267 all new PLATO customers.

In addition to tracking new and legacy product customers who license PLE, we monitor expansion and renewals of existing subscriptions. In the second quarter of 2008, approximately 10% of our PLE customer base placed expansion orders for a total order value of $1.7 million up from $1.2 million in the first quarter. With regard to PLE renewals, as I mentioned in my opening remarks, we have renewed 91% of the value of all subscriptions eligible in the first half of fiscal 2008.

The number of PLE registered users grew 18% during the quarter to 716,000. These users, mainly students and teachers, are in 965 school districts, community colleges and other educational institutions across the United States, and a 15% increase during the quarter. Expressed differently, students enrolled in 2,400 schools and colleges are taking instruction using PLE.

The length of subscription periods is a key variable in measuring our customers’ commitments to our solutions. The average length of PLE subscriptions sold was 20.3 months in the second quarter up from 16.9 months in the second quarter last year and 15.3 months in the first quarter this year.

Longer subscription periods result in larger order values and indicate customer confidence in our solutions. They also provide more predictable revenue streams and more time and opportunity for account managers to expand customer relationships. Subscription margins continue to improve as subscription revenue growth is now outpacing increases in product amortization.

Gross margins on incremental subscription revenues have been greater than 60% since the beginning of fiscal 2008. And subscription margins are expected to continue to improve going forward. We continue to capitalize on the opportunities provided by the SaaS business model to achieve operating leverage.

In 2007, we took $19.1 million out of our cost structure compared to 2006, and we are on track to achieve additional savings in fiscal year ‘08 and into fiscal year ‘09. These savings together with increasing subscription revenues and the moderation of our product investment spending will help us achieve our dual goals of profitability and strong cash flow in fiscal 2009.

Deferred revenue was another key forward-looking indicator. Our deferred revenue balance of $41.7 million at the end of the quarter is projected to contribute approximately $22 million to revenue for the balance of the fiscal year 2008. These are some of the metrics we’re using to measure progress and to improve our execution. And we will continue to refine these and other important measures of progress and share them with you.

Now a survey released last month and commissioned by the Software Information Industry Association or SIIA, reported that an answer to a question on the use of learning management systems, PLATO Learning was the top brand in the K-12 market. The results of this study confirmed the historical strengths we have and the significant opportunity remaining to transition our large customer base to the newest generation learning management system, PLE.

Our second quarter financial result and progress on key metrics confirmed to us that we are making progress with our strategic plan and goal of generating revenue and cash flow growth that will reward our shareholders. Revenue and orders are growing and our margins, cost structure, and profitability are improving.

We are gaining momentum by acquiring new customers, transitioning our large customer base to PLE, customers are expanding and renewing their subscriptions. The conversion to a subscription business has presented challenges, and the transition has taken longer than originally expected. We are however making real and sustainable progress, and our confidence in our ability to execute for shareholders remains high.

That concludes our formal remarks. We’ll now take any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Bob Evans - Craig-Hallum Capital.

Bob Evans - Craig-Hallum Capital

Can you comment a little bit further as it relates to your 2009 goals and help me get there in terms of profitability and maybe a little bit more clarity as it relates, in terms of I think you said $12 million annualized by the end of the year in terms of product development versus $18 now. I just want to make sure I am looking at it the same way you are?

Robert J. Rueckl

I’m not going to give you real detailed guidance for 2009, Bob, at this point, but we do have a goal as we said of being profitable in 2009.

Bob Evans - Craig-Hallum Capital

Are you saying on a GAAP basis?

Robert J. Rueckl

That is correct. And so we will obviously we are seeing the momentum in our subscription revenue growth. That will continue, and we have cut out the costs that we talked about. Now the spending that we cut is a mix of capital spending. So, if you take the development cost of $12 million exiting the year. So, that’s the fourth quarter run rate if you took our fourth quarter multiplied by four, you’d come up around $12 million. About 75% of that is capital, and about 25% of that is expense.

Bob Evans - Craig-Hallum Capital

So that would hit the P&L also.

Robert J. Rueckl

Yes, right, right.

Bob Evans - Craig-Hallum Capital

So from a cash standpoint the reduction would be say 18% to 12%, but from a P&L standpoint, it might be 25% of that.

Robert J. Rueckl

That’s right.

Bob Evans - Craig-Hallum Capital

Will there be any meaningful change in depreciation and amortization next year?

Robert J. Rueckl

It will start to come down a little bit it. You’re going to have a couple competing things there. That number is still increasing as we’re amortizing the investment through the first half of ‘08. But as our investment comes down on the second half of ‘08, that amortization will come down as well.

Bob Evans - Craig-Hallum Capital

And you said these, from a cost standpoint, these changes from a headcount standpoint have already occurred or they will occur?

Robert J. Rueckl

They have occurred.

Bob Evans - Craig-Hallum Capital

And you said there was going to be a 50% increase in subscription revenue is that correct?

Robert J. Rueckl

No, in our deferred revenue balance, at the end of the year, we think it can get up close to $60 million.

Bob Evans - Craig-Hallum Capital

Would you expect most of that increase to be in the subscription bucket?

Robert J. Rueckl

Yes, there will be a combination but most of it is in the subscription bucket. The portion of orders that are for services are also deferred.

Bob Evans - Craig-Hallum Capital

And the subscription orders that you had this quarter, which would most of them fall in the 12-month bucket or greater than 12 month bucket?

Robert J. Rueckl

Well the average, the weighted-average subscription period I think was 20 months so 20.5 so it’s right in between the one and two year, a little more towards the two-year bucket.

Bob Evans - Craig-Hallum Capital

Is that just for this quarter or average of everything?

Robert J. Rueckl

That was just for this quarter, and if I look at a 12-month basis it runs in around 18 months is a really good, right around that area.

Bob Evans - Craig-Hallum Capital

And I know this is a low point from a cash flow standpoint, as we look at the rest of the year, how should we think of free cash flow between now and the end of the year and in fact, how should we look at the year?

Robert J. Rueckl

Well I’m not sure we get the positive free cash flow in the year, for the full-year right. We will recover a significant portion of where we are year-to-date. The $1.6 million in restructure cost is all cash. There is some payout of vacation benefits and other things that’s going to hit our cash so barring without that restructure charge, I think we’d have gotten to positive free cash flow for the year or close to it.

Bob Evans - Craig-Hallum Capital

But so from an operating basis, you’d be there, without the charge.

Robert J. Rueckl

Yes, the restructure is going to be in the operating. It’s going to come through in the operating line as well.

Bob Evans - Craig-Hallum Capital

And that will hit when?

Robert J. Rueckl

Well, that’s Q3. Yes, most of the terminations were effective, or have already occurred.

Bob Evans - Craig-Hallum Capital

And then gross margins, how should we think about gross margins, particularly subscription gross margins going forward? Where can they get to?

Robert J. Rueckl

Well, for this year I think, they’ll end up around 50% or a little bit better than that in the fourth quarter. So we’ll see a nice march up to 50% each quarter between now and then.

Bob Evans - Craig-Hallum Capital

And as you get more scale next year, should you continue to grow from there or what can they get to or stabilize at?

Michael A. Morache

Well, that’s a hot debate. We know we can get into the 60s. There is no disagreement amongst our think tank here that we can get into perhaps upper 60s. I think there’s ample reason to believe we can get above 70%. Now, this business is set up to scale very nicely now. And when we look at the capacity of our infrastructure and the ability to add customers at a very low incremental cost, we continue to believe high 60s and I think through continuous improvement 70s is a reasonable target for subscription.

Bob Evans - Craig-Hallum Capital

Can you get 60% sometime next year on a quarterly basis?

Robert J. Rueckl

We’re not prepared to talk about that, I’m only guessing but we’re going to see those continue to increase. Mike and I do agree that that those things, we’ll see those get into the mid to upper 60s. They aren’t going to go backwards. You will see continued revenue growth. We’re going to see some moderation in our amortization as our product investment comes down, but I haven’t modeled it out there.

Operator

We have no further questions.

Michael A. Morache

Thank you again for joining us today. We appreciate your continued support and look forward to updating you at the end of our third-quarter. Thank you and goodbye.

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