Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Jim McGeever – CFO

Zach Nelson – President and CEO

Analysts

Phil Winslow – Credit Suisse

Laura Lederman – William Blair

Sasha Zorovich – Goldman Sachs

Terry Tillman – Raymond James

Tom Roderick – Thomas Weisel Partners

Michael Huang – ThinkPanmure

Charlie Di Bona – Sanford Bernstein

Kash Rangan – Merrill Lynch

Mark Murphy – Piper Jaffray

Lawrence Petrone – W. R. Hambrecht

Richard Baldry – Canaccord Adams

Matthew Carson – Pacific Crest Securities

NetSuite Inc. (N) Q2 2008 Earnings Call Transcript August 5, 2008 2:30 PM ET

Operator

Good day, everyone, and welcome to this NetSuite Q2 earnings call. As a reminder, today’s call is being recorded. I would like to turn the call over to your host, Mr. Jim McGeever. Please go ahead.

Jim McGeever

Thank you. Good afternoon everyone and welcome to NetSuite's second quarter 2008 financial results conference call. We will discuss the results for our quarter which ended June 30th. By now you should have received a copy of our press release which was released today after the market closed and furnished on Form 8-K to the SEC. Joining me today on the call is Zach Nelson, our Chief Executive Officer.

Today's call will begin with Zach providing a brief overview of our record results with some color on the drivers of the business. Then I will review our key financial results in more detail and provide our financial outlook for the third quarter and full-year 2008. We will then take some questions.

Today's call is being recorded and a replay will be available shortly following the conclusion of the call. To access the press release, the financial detail or the webcast replay, please access web investor relations web site at www.netsuite.com/investors.

During this call, we will be referencing both GAAP and non-GAAP financial measures and wish to note that the GAAP reconciliation information is provided in the press release and on our web site. All of the non-revenue financial measures we will discuss today are non-GAAP unless we specifically state that the measure is a GAAP number. The non-GAAP measures exclude stock-based compensation expense and the amortization of intangible assets related to the OpenAir acquisition. Some of the information discussed during this call, particularly information regarding our revenue, including expectations concerning revenue growth, non-GAAP net income and loss, business strategy, customer demand, market observations and future product plans are based on information available as of today, August 5, 2008.

In addition, some of the statements we will make on today's call will constitute forwardlooking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. We disclaim any obligation to update any forward-looking statements. The risks and uncertainties that could cause our results to differ materially from those expressed or implied by such forward-looking statements are summarized in the press release we issued earlier today. They are also described in detail in our 10-Q filed with the SEC on May 13, 2008 which is available to you on our investor web site and which I encourage you to read.

Finally, customers who purchase our services should make their decisions based on features that are currently available. Please be advised that any unreleased services or features of NetSuite referenced in today's discussion or other public statements are not currently available and may not be delivered on time or at all.

With that, I will now turn the call over to Zach Nelson.

Zach Nelson

Thank you, Jim, and thank you everyone for joining us today. Anyway you look at it, our second quarter of 2008 was another stellar quarter for NetSuite. When compared with recent trends seen in the market in which we play, specifically the mid-market ERP business application space, the performance was fantastic. In this past quarter, we saw traditional mid-market application vendor sale stall and shrink. Clearly, market share continues to shift from traditional on-premise solutions to on-demand software. This quarter also witnessed SAP backing away from their predictions of expansion in the mid-market with an on-demand product. Instead, they chose to raise support prices on their captive customers to generate growth.

In contrast, we were able to post record results and marked our 35th straight quarter of increased revenue. We were at the high end of our outlook for revenue and at the low end of our outlook for pro forma net loss per share. Our revenue grew at 43% year-over-year and our deferred revenue grew at a much faster rate than in the first quarter of ’08 and the same period of last year. We are definitely taking advantage of our significantly leading product, time to market, and strategy to extend our position as the only relevant provider of on-demand ERP-based business applications in the world. By all measures in Q2, we believe NetSuite remained the fastest growing public ERP-based application provider.

On the top line, we had revenue of $36.6 million, a 43% increase over the $25.5 million recorded in the second quarter of ’07. Non-GAAP net loss for the second quarter was $0.01 per share or $900,000 in absolute terms, a 34% improvement over the net loss we posted in the second quarter of ’07. This is in line with our stated objectives of reinvesting in top line growth while managing the bottom line within fairly tight constraints.

One other notable metric to point out is in the area of deferred revenue. We more than doubled the rate of growth of short-term deferred quarter-over-quarter and to avoid any confusion, OpenAir only added $161,000 to the short-term deferred balance. These top-level metrics show continued execution against the product distribution and business strategies we laid out during our IPO. In particular and as we discussed during our Analyst Day in June, these metrics also point to our success in moving upmarket to serve mid-sized companies. For example, earlier today we announced NetSuite rollouts at two mid-market companies and a department of a large enterprise. The very different ways these companies have deployed NetSuite illustrate the breadth of our ERP, CRM, and e-commerce functionality.

Intuitive Surgical, a fast-growing publicly traded $600 million company and the leader in operative surgical robotics, selected NetSuite CRM to integrate and manage a number of complex business processes that they provide to hospitals nationwide. Wasserman Media, a leading sports marketing agency, replaced Microsoft Great Plains with NetSuite to manage complex business processes unique to their industry such as partner athlete commissions, athlete management, and media purchases. And finally, Nestle UK, the British arm of the world’s foremost nutrition, health, and wellness company, used NetSuite Ecommerce to build a completely integrated web store in six weeks under rigid requirements. These and many of our other customers were all implemented by NetSuite professional services. As we discussed at our Analyst Day presentations, we have made significant investments in professional services and support, and the metrics we use to manage those aspects of our business continue to improve.

Our average customer rating for professional services implementation is now 4.2 out of 5. Our average project duration is holding steady even with our continued growth and the fact that we are adding customers with more complicated operations.

Ratings for our customer support also showed marked improvement. The number of customers that rated our support a 4 or a 5 out of a scale of 5 increased from 47% in Q1 to 84% in Q2. We have achieved this productivity by creating a staff to peak model and investing in intensive training for the support staff we hire. So, while we can always do better, we are quite happy with the dividends we are seeing from our investment and customer implementation and support. And today, I view professional services and customer support as key competitive advantages as significant as our product leadership is.

The three new customer implementations we announced today describe just a few of thousands of ways companies are using NetSuite to improve their business. In Q2, we added more than 400 new customers and in keeping with the theme of this call, we increased our average selling price notably. As I have mentioned before, when I joined NetSuite in 2002, our average billings was roughly $149 per customer per year. In 2007, our average revenue was roughly $20,000 per customer. In Q2 ’08, I am happy to say our annual contract value for new sales cracked the $30,000 per customer level for the first time in our history. This increase in average selling price has been driven by two factors. First, we brought to market a great deal of new advanced functionality such as NetSuite OneWorld.

The quality and power of the NetSuite product has been widely heralded and the awards continue to roll in. This quarter, we received the Software & Information Associations CODiE Award for Best E-Commerce Solution and our OpenAir subsidiary won the CODiE for Best Business Software Application overall. We were named in ISM’s top 15 CRM SMB software award family. We received a 5-Star award in the CPA Technology Advisor Accounting Software Review, and last but not the least, Industry Analyst Gartner positioned NetSuite in the Visionaries Quadrant of its magic quadrant for e-commerce. So, our development team continues to produce, what I believe, is one of the best software applications ever written.

The second factor adding to average selling price and customer growth is the accelerating shift across the industry to software service and because the breadth of our on-demand suite encompasses ERP, CRM, and e-commerce functionality, NetSuite has more exposure to that growing demand than perhaps any other software company.

So in closing, we were very pleased with the quarter. We have a great management team and we’re incredibly focused on taking advantage of the opportunity in front of us. We will continue to double down [ph] on areas that have showed success whether that’s in product development, in constantly improving professional services and support, or in expanding our new business sales efforts, all of which led to our excellent Q2 results and which have set the company up for a tremendous future. Now, I’ll turn it over to Jim for more financial detail on the quarter’s results. Jim?

Jim McGeever

Thanks, Zach. Our second quarter of 2008 was another excellent quarter for NetSuite as we continued to make progress on our financial and strategic targets. Q2 was our 35th straight quarter of increasing revenue. We are at the high-end of guidance of revenue and the low-end of pro forma net loss the share. Short-term deferred revenue growth was strong growing faster than Q1 2008 as well as Q2 2007. Our outlook for 2008 for revenue, net income and loss per share is unchanged. I would like to remind you that our discussion today will be based on non-GAAP financial measures which excludes stockbased compensation expense and the amortization of intangible assets related to the OpenAir acquisition.

Let’s turn to our financial statements for the second quarter of 2008. Total revenue for the quarter was $36.6 million, a 43% increase over the second quarter of 2007 and a 7% increase over the first quarter of 2008. As we have discussed during our Analyst Day in June, our increasing revenue continues to be driven by the continued successful execution of our company's strategy, particularly as we continue to sell to logic customers an increased our average selling price which in Q2 2008 was the highest it has ever been. International revenue represented 20% of our global business in the second quarter, growing faster than our overall business. The percent of our revenue coming from outside of the Americas has increased every quarter since we started tracking this metric, another indication that NetSuite addresses a global opportunity.

As described in our prior 10-Q and 10-K, we recognized $1.5 million of revenue in Q2 related to the distribution rights for our localized on-demand application suites for the Japanese market. We continue to recognize $1.5 million in revenue related to our localized Japanese product in each quarter of 2008 and through the first quarter of 2009. Overall gross margin for Q2 2008 was 70% compared to 71% in the first quarter of 2008. This decrease was primarily due to additional investments in professional services and support staff. We expect our gross margin to stay roughly flat with Q2, through the remainder of the year.

Turning to our operating expenses, product development expense was $3.9 million in the second quarter, an increase of 8% over the previous quarter, primarily as a result of the addition of development headcount for OpenAir and other additional hiring. 2008, we expect product development expense to be roughly 12% to 13% of our revenue. Sales and marketing expense was $18.8 million in the second quarter, an increase of 8% over the first quarter of 2008. The increasing expenses was primarily due to additional sales headcount and spending on marketing programs. As we have previously discussed, we plan on significantly increasingly our sales force in 2008 and our hiring continues to be on track to meet that goal.

G&A for the first quarter was $4.6 million, an 8% decrease from the previous quarter. This decrease reflected a reduction in legal, audit, and tax and other expenses generally incurred in the first quarter of each year, offset by additional spending for SarbanesOxley compliance and for the OpenAir acquisition. For 2008, we expect G&A expense to be roughly 12% to 13% of our revenue. We added 136 employees in the second quarter of 2008, an increase of 18% quarter-over-quarter for a total of 901 employees at the end of the quarter. The increase in headcount was largely related to increases in support, professional services and sales, as well as the addition of employees related to the OpenAir acquisition. In Q2 2008, we recorded a $361,000 income tax provision. This was principally related to our international entities. For domestic tax purposes, we expect our net operating losses to offset any earnings for at least five years.

On a non-GAAP basis, net loss for the quarter was $900,000, in line with the outlook we gave following the OpenAir transaction versus a net loss of $420,000 in the prior quarter.

As we had mentioned in our press release announcing the OpenAir acquisition on the EITF 01-03 Accounting in a Business Combination for Deferred Revenue of an Acquiree, we will not be able to recognize any of the deferred revenue that was on the balance sheet of OpenAir at the time of acquisition. As such, the impact of the acquisition on our revenue in 2008 is not expected to be significant and as a result, the acquisition is expected to lead to increase GAAP and non-GAAP losses in 2008. However, we continue to expect the transaction to be neither dilutive nor accretive to our 2009 non-GAAP earnings.

The EPS loss for the second quarter on a non-GAAP basis was negative $0.01 as compared to negative $0.02 in Q2 2007. The weighted average basic and diluted shares outstanding used for calculating EPS was 60.2 million shares for the second quarter. As a reminder, a non-GAAP reconciliation is available on our web site.

Cash flow from operations for Q2 was negative $1.8 million as compared to positive $1.5 million for Q1 of 2008 and a positive $1.3 million for Q2 of 2007. As we had indicated at our Analyst Day, cash flow from operations was negatively impacted as a result of international tax payments made during the quarter related to prior periods. We expect cash flow from operations to continue to be negatively impacted in subsequent quarters of this year due to payment of tax liabilities associated with the OpenAir acquisition. Cash flow used in investing in Q2 2008 was $30 million as compared to $1.1 million for Q1 of 2008 and $1 million for Q2 of 2007. This increase primarily consists of $28.2 million related to the OpenAir acquisition.

Let me turn to the balance sheet. We closed the quarter with $137.4 million in cash, down from the end of last quarter due to the purchase of OpenAir in June. Accounts receivable ended the quarter at $21.5 million up from $16.2 million at the end of the first quarter. This increase reflects the strong bookings that we had at the end of Q2. Days billing outstanding, the metric that we use to measure receivable trends, was unchanged in the quarter. While most of our business is not billed annually, some customers are billed quarterly or on customized payment schedules even though customers generally have annual contracts.

Short-term deferred revenue totaled $68.9 million at the end of Q2, an increase of $1.8 million over the prior quarter. As expected, the OpenAir transaction did not provide a significant impact to short-term deferred revenue and short-term deferred revenue related to OpenAir was $161,000, all of which was generated from post acquisition transactions. If you exclude the impact of short-term deferred revenue of the revenue recognized relates to our localized Japanese product, then short-term deferred revenue rate of growth grew by 129% quarter-over-quarter or by 5% in Q2 2008 as compared to 2% in Q1 of 2008 and to 3% growth rate in Q2 of 2007. Excluding the effect of Japanese transactions, short-term deferred revenue was $63.4 million versus $61 million at the end of the first quarter and $52.9 million at the end of Q2 2007.

Long-term deferred revenue totaled $9.3 million at the end of Q2, an increase of $330,000 over the prior quarter. We usually expect the long-term deferred revenue balance to decrease every quarter as our customers continue to shift from multi-year to one-year contracts. There were two large multi-year contracts both in Q2 of 2008 that increased the long-term deferred revenue balance. In the second quarter, we incurred $180,000 of expenses related to the amortization of intangible assets related to the OpenAir acquisition. We expect to incur $623,000 of amortization expense in the remaining quarters of 2008 and each quarter of 2009. These expenses are not reflected in our pro forma results. Stock-based compensation expense for the second quarter of 2008 was $2 million as opposed to $1.6 million in the prior quarter. We usually make stock-based grants in the third quarter of each year and therefore anticipate stock-based compensation expense to increase in future quarters.

Now, I would like to move on to our forward-looking financial outlook which is covered by the cautionary language outlined at the start of this call and is based on assumptions which are subject to change over time.

For Q3 2008, we are projecting revenue in the $40 million to $40.7 million and nonGAAP net loss in the range of negative $1.5 million to negative $900,000. This indicates non-GAAP EPS of approximately negative $0.02 to negative $0.01. Our projections assume a weighted average share count for Q3 of 62.3 million shares.

For the full-year 2008, we are reiterating our previous outlook to be in the range of $156 million to $159 million and non-GAAP net loss in the range of negative $3.5 million to negative $2.5 million. This indicates non-GAAP EPS of approximately negative $0.06 per share to negative $0.04 per share. Our projections assume a weighted average share count for 2008 of approximately 61.3 million shares.

We are very proud of our company’s financial performance in the second quarter of 2008 and continue to look forward to a successful 2008.

That concludes my prepared remarks. With that, I will turn the call over to Zach for some closing comments.

Zach Nelson

Thank you, Jim. And before we open the lines for questions, I'd just like to let you know that both Jim and I will be speaking at a number of upcoming investor conferences as well as both of us will be on the road meeting with many of our investors. So we look forward to seeing you at either the conferences or in the one-on-ones that we will be holding with a variety of banks over the coming weeks and months.

With that, I will turn it over to the operator who can open the line for your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We will take our first question from Phil Winslow with Credit Suisse.

Phil Winslow – Credit Suisse

Hi guys. Jim, you mentioned on the call that you maybe saw some change in billings terms. Just curious if you did see more quarterly payments versus annual just given sort of the economic environment and if that’s the case, wondering if you could give us a sense of impact on deferred revenue. Then Zach, just on the long-term deferred revenue front, you talked about a couple of large deals positively impacting long-term deferred. How shall we think about – just long-term deals for sort of NetSuite longer term, is this the kind that we are going to see again or was this just sort of a one-off?

Jim McGeever

Thanks Phil, so to just respond on the billing term. It was not really more customers asking for quarterly payment. It is not that unusual especially in larger deals where there is a custom billing schedule and so the reduction that we saw in the average billing term was really a result of these larger deals having this custom billing schedule such as they may have 50% on day one and 50% three months from now. It’s not typically meaning that they will be paying quarterly on a going forward basis. It wasn’t really the regular deal, it was some larger deals.

Zach Nelson

Phil, this is Zach. To your question about the large multi-year deals. Our primary – our typical practice is to do one-year deals for a variety of reasons that we have covered with many of you in the past. We just think that’s the better way to run the business, but to the same point that Jim made regarding larger deals and the payment terms and the changes in payment terms you might see as we do those deals, we also saw this quarter larger deals where customers wanted multi-year contracts. So we try to do what the customer wants in most cases and not really force our process down their throats. And in those two particular cases, it made sense for them and for us to consider a multi-year deal which we are happy to do. It’s just not our standard practice and you should not see us going out and actively saying everything is going to be a three-year deal. So it was really just based on customer needs and the like.

Phil Winslow – Credit Suisse

Got it, thanks guys.

Operator

And we’ll take our next question from Laura Lederman with William Blair.

Laura Lederman – William Blair

Yes, thanks so much for taking my questions. I have few. One, did you see any weakness in the economy in any vertical markets like little financial services companies or manufacturers or anything, so just kind of give us a sense of the economic outlook here and also in Europe as well. And Jim, this is a question for you, isolating out Japan and the change in payment terms since we don’t kind of have any average bill cycle, can you give us a sense of how bookings were – kind of help us figure that out? And then I have a few more questions too. Thanks.

Zach Nelson

This is Zach and I will talk to the economic outlook question. We have been asked this question I think all year long and we have been pretty consistent in saying, as you look at the leading indicators of our business, leads and pipeline, we haven’t seen an economic impact and in fact to date those two leading indicators have grown faster than historical. I think if you look at this quarter, particularly the number of customers, 400 customers which is exactly right in the middle of what we typically sign in a given quarter and the fact the average selling price was going up, again, I don’t think you see enormous economic impact on those numbers. It’s basically business as usual for NetSuite. In terms of various vertical markets that you talked about, we’ve also said, we don’t have a ton of exposure in financial services and construction and those markets. We would like to have more of course, we'd like to have more in every market, but we don’t have an enormous amount of exposure to those markets, so I don’t think I can really comment on it – those verticals specifically. The one thing I will say that we have said, we’ve said it with some reticence, we’ve always said, every – almost every vendor out there says there are countercyclical, but as we’ve gone through this economic cycle, I really do believe that it is true in NetSuite’s case. Many of you heard the Asahi Kasei story at our Analyst Day where David Stover got up and said, we were using SAP and we were spending 3% of revenue on managing SAP to one-tenth of 1%, and we moved to NetSuite. Those kinds of economics are very compelling in an economic downturn. So, I think we are in a great position when economies are booming and nobody wants to have economic slowdown but certainly, the economics of SAP and more importantly, the economics of NetSuite, the economics of a multi-application solution that is integrated are really compelling on the downside as well. So, I think that has been our experience in the first six months of the quarter and it certainly seems to be what we’re looking at going forward.

Jim McGeever

And just on the breaking out of the deferred revenues, so there is actually a table on our web site that breaks down our short-term and long-term deferred revenue and it backs out the Japanese localization deal that we did in 2006. And the numbers I quoted in terms of growth did exclude our localization deal that we operate in house and hopefully can see with that short-term deferred revenue that we are very strong in the quarter and it was driven by having strong billings towards the end of the quarter. We didn’t see a change in the DSO or days billing outstanding that we measure.

Laura Lederman – William Blair

Okay. Following up, a little discussion on the competition, if you will, who you are seeing more or who you are seeing less, in my sales force charts I did here, just seeing a little bit more of you. So, is it pretty much still Great Plains and then in CRM sales force and from accounting vendor just to get a sense – I know you are still replacing a lot of QuickBooks?

Zach Nelson

Yes. So taking it from literally on global perspective, it does vary by geographic regions, so we are doing quite well in Australia, the guy that you can replace a lot there would be MYOB. In the UK, doing quite well in the UK. You will see a lot of Sage replacement on the back office. In the U.S., on the back office, the primary competition is a Great Plains like solutions on the back office. The second point is, as you point out, typically, we are not competing with just one application. We are usually competing with multiple applications, something in the back office and then typically something in the front office and so the most likely front office competitor in that particular environment in many cases is salesforce.com. Now that said, even if you just look at U.S. and you look at the competitive environment, let's just say it's Great Plains and salesforce.com, that combination while the most common, you still only see in something like 10% of the deals. So, our point has always been in the opportunity for NetSuite in the mid-market is it is really, really fragmented. So while we may see that a lot, you only see a 10% of the time, 90% of the time it is a whole different set of competitors. I guess, the other thing that I would say and you saw this in the average selling price is while we certainly do a lot of upgrades or migrations from QuickBooks as people outgrow that platform, we are also seeing customers starting to replace traditional mid-market products like EFICOR [ph], like Great Plains and even to some extent, SAP with NetSuite. So we’ve got some really interesting announcements I think coming forward next quarter, very similar to the Asahi Kasei example where SAP is the corporate instance that they run the entire company on, but you’re starting to see NetSuite begin to become a divisional solution that is surrounding the corporate SAP application. We will have some interesting announcements in that regard in this quarter.

Jim McGeever

Now the other thing we’ve seen, (inaudible) a change in you, people entering the market, I don't think we had a single deal in the Q2 where we saw business by design.

Operator

We will take our next question from Sasha Zorovich with Goldman Sachs.

Sasha Zorovich – Goldman Sachs

Well, tell a little bit more about your – obviously you’re showing a nice international growth. So, specifically there kind of adding on to this commentary you are providing regarding Australia and the UK, specifically how are those markets sort of different and specifically the outlook, is it benefiting you anymore in terms of the potentially higher growth there and changes there?

Zach Nelson

Well, we have always said that this opportunity – this gap between QuickBooks and SAP is a global opportunity. It is just that the players in each market are different. And as we talked a little bit about MYOB in Australia – in Japan, there’s a company called Yayoi on the low end and the gap between SAP is from Yayoi to SAP. So every market is different. Part of the reason you are seeing the growth that we are seeing, particularly in Asia Pacific is we have invested in good number of sales bodies there. So, for example, in the last quarter, we opened our Hong Kong office and staffed it with three or four people. So, you are starting to see opportunities that we should have been seeing all along now they have sales resources on there. We have a great sales organization in Asia headed by the guy that initially kicked off our UK operations. He is now running our Asian operations. So it’s great management as well; they are taking advantage of the opportunity. The other thing that I would say about those markets, it is somewhat different than the U.S. For example, if you look at the Australian market, there is something like 10 companies that are billion dollars. Everything else is a small and mid-sized market there. So, the opportunity in many cases is very large outside the U.S. For – the SMB opportunity, I believe is far larger than the enterprise opportunity in some place like Australia.

Sasha Zorovich – Goldman Sachs

Thank you.

Operator

We will take our next question from Terry Tillman with Raymond James.

Terry Tillman – Raymond James

Hey, guys. Thanks for taking my question. First question, just relates to I think you already talked about or you said on the last call, about 50 incremental sales reps being added in ’08, that substantial increased your sales capacity. How do you see to benefits from the productivity playing out from that much (inaudible) sales force? Is that really coming to a tone [ph] in more of the first half ’09 or some more of the second half ’09 event?

Zach Nelson

Well, in terms of hiring those bodies, I did not quite catch the numbers, but we are right on target for the additions we are making in the sales force to date and so, we are going to continue hiring through Q3 to hit our targets on sales hiring. Anecdotically, to date, the productivity of those reps seems to be on the same ramp that our historical productivity has been as we add new sales reps. So we definitely see that paying off. I believe you will see the incremental result of that productivity, however, obviously in FY ’09 rather than this year.

Terry Tillman – Raymond James

Okay, and then, Zach, in terms of NS-BOS, in the past, you’ve thought of it as a way to further verticalize your own product offerings and I know it is probably early within NS-BOS, but could you make a comment on, is it becoming material to revenue, is that more of a ’09 event or just where you are with progress running NS-BOS? Thank you.

Zach Nelson

Yes, it is a good question. NS-BOS, as you pointed out, is a very important strategy as we begin to verticalize NetSuite and that is our idea with NS-BOS. NS-BOS is really our platform strategy and unlike other platform strategies where companies like Google are saying, come to Google and just build random applications in the cloud. That is one strategy and that is fine. Our strategy is really to take our tool set, the SuiteFlex tool set and enable third parties to build verticalized version of NetSuite to solve specific business problems related to agricultural dealer equipment, for example, or electronics distribution or computer resale, really customizing NetSuite specifically for those applications. So, yes, I do believe it is early – we are early in that process. I have been very excited just to seize the ground swell of developers build applications on NS-BOS that I did not know what's happening as we are starting to see momentum that is really self sustaining in that development community. We’ve already had some great successes with partnerships there. For example, we have a number of companies that build fixed asset modules that run literally right on top of NetSuite. We do not have fixed assets built into the product, but now our customers have multiple choices for fixed assets. That is really a horizontal app. We are also now seeing the emergence of vertical applications. We have one great partner building a manufacturing application on top of – a deeper manufacturing application on top of NetSuite and they have domain expertise about manufacturing and they are going to take it to market. So, a variety of applications being built that are very exciting. But again, I think, your assessment is right, in ’09 and even in ’10 impact to the company.

Operator

Thank you. We will move on to our next question from Tom Roderick with Thomas Weisel Partners.

Tom Roderick – Thomas Weisel Partners

Hi, guys. Thanks and good afternoon. Wanted to dive back in on the OneWorld discussion and see if you could offer a little bit more detail in terms of how that pipeline is shaping up that you have been very positive on the pipeline itself. Can you talk a little bit about the sales cycles? Are you seeing longer sales cycles there? And then as you complete those deals, are there anymore stringent revenue recognition policies associated with these multiple element, multiple geography deals? Thanks.

Zach Nelson

Yes. Hi, this Zach. I will speak to the OneWorld opportunity. We are very bullish on OneWorld. There is literally no other product like it on the planet. The ability to run multiple subsidiaries and multiple companies in a single instance of NetSuite and then consolidate those in real time across any currency across, any hierarchy, it really is a spectacular capability. So, I think the last time I spoke about this, we said we had about 100 customers. We are up to about 130 now since we last spoke in June. So, you are seeing a 30% growth in the pipeline. If you recall from Analyst Day, was healthy and was incremental to the trend line of our pipeline, so I see nothing but great success in the offering for OneWorld. And back to the earlier question about our international opportunity, OneWorld is tailormade for markets like Europe and Australia where almost every company is operating in multiple countries and they need to have multiple subsidiaries and multiple currencies and multiple tax regimes. They need to run those businesses independently, but also get a consolidated global view and not just across accounting but across their CRM forecast, across their marketing efforts, the ability to run multiple websites, it really is an extraordinary capability. So, there is going to be long, long life to that product and I believe it is going to continue to grow as an important component of our revenue.

Jim McGeever

On a (inaudible) separate issue. It’s not (inaudible) that larger deals can sometimes have more complex revenue recognition criteria, but basically, it is not to do with whether it is a OneWorld business but a lot of times, when we do have to play revenue recognition if we have to deliver complex customization. That could be in OneWorld. They could just as equally be in smaller companies as well which are not OneWorld. And I wouldn’t say we have seen any particular trend in regular run of the mill business in terms of increasing complexity of deals where we have had to delay revenue recognition.

Tom Roderick – Thomas Weisel Partners

Okay, good. Jim, just a quick follow-up for you. I may have missed it in your commentary on gross margins, but there was a dip in gross margins this quarter. How much of that was related to the new data center and what sort of outlook should we see in the coming quarters on gross margins here? Thanks.

Jim McGeever

The outlook on gross margin is basically, we expect it to be around 70% for the rest of the year, which could give us some new – in terms of what we have been saying. Not too much of an impact on the new data center. In fact, after we did the OpenAir acquisition, they already have a need for data centers, so there's a little bit of delay while we consolidate both data centers and just basically one integrated data center. We haven’t seen an impact of that yet and I don’t think that you’ll see a significant impact on the gross margin line when we do go live with that. Now, the big change – or not big change, but we did have some increased investment in professional services and support, which is really driven by providing increased service to our customers, and Zach talked about some of the metrics that we have been able to achieve in those areas. I think that was well worth it from an investment front.

Tom Roderick-Thomas Weisel Partners

Okay. Thanks very much.

Operator

We’ll go next to Michael Huang with ThinkPanmure.

Michael Huang – ThinkPanmure

Thanks very much guys. Quick question for you. So nice to see the improved deferred revenue growth. I was wondering how that compared with internal expectations. And as a result of the accelerating revenue growth, deferred revenue growth, how come you weren't able to take up revenue guidance up a bit as a result? And then another question unrelated, in terms of the OneWorld opportunity in the near term, are these more with existing customers or new customers? Thanks.

Jim McGeever

So, on the deferred revenue, so I think we tried to break out the Japanese localization revenues to give you a clearer picture. And I think if you look at the trends that we saw in 2007, you’ll see that deferred revenue growth in terms of the trends was very consistent. It was only a strong quarter for us in terms of deferred revenue growth. Right now we have our guidance out there and we feel comfortable with it.

Zach Nelson

Yes, and speaking of OneWorld and also on the guidance, I mean we are one of the fastest growing software company, not just software service, but fastest growing software companies in the world. This quarter was 43%, so it’s – I think we are growing the business responsibly and we’re managing the business aggressively and we are growing it very rapidly. So, we’re really happy with the guidance that we have out there, particularly when you look at the marketplace around us and particularly ERP outside of the business. So, there is enormous opportunity for us that we’re going to take advantage of. On the OneWorld front, in terms of existing customers versus new customers, I really don’t have a really solid answer for you there. My guts says that we’re sort of – we are through an initial cycle with the existing customer base and the incremental as new customers but that is really just a gut at this point. I haven’t analyzed it that closely.

Michael Huang – ThinkPanmure

Thank you.

Operator

And we'll go next to Charlie Di Bona with Sanford Bernstein.

Charlie Di Bona – Sanford Bernstein

Zack, I was wondering if you could characterize the selling environment into the smaller accounts. And you got sort of a normal number of sales, number of clients this quarter, ASPs are up, that seems to indicate you’re having success sort of moving up into larger accounts. But it could also be that you are sort of biased in that direction. Can you maybe talk about the impact on your smaller clients?

Zach Nelson

Yes, so in terms of new business, Charlie, we are definitely biasing towards larger accounts and that is not necessarily larger in terms of company size. It is really larger in terms of their relationship with us. At our analyst day, Jim put up a slide that really showed that customers that are paying us less than $10,000 a year annually, churn is at a pretty high rate. Now it is a very small percentage of the revenue. It is a good number of very small customers, but – so we have used that metric more than the size of the company to really establish who is going to be successful with NetSuite and who is going to grow with the company. So we could have (inaudible) with the customer today who is telling us how great the product is, it is a five-person business. They love the product. They are doing really well with it. Sometimes you can have a $100 million business that is paying you less than $10,000 a turn. So, it really have to do with what the customer is doing with the product and what value they see in the product, and that is really judged in this sort of line, at least that we have been able to analyze it about $10,000 per year and recurring.

Charlie Di Bona – Sanford Bernstein

Thank you.

Operator

We’ll take our next question form Pat Walravens with JMP. And your phone line is open, if you check your mute button or pick your handset, we cannot hear you at this time.

And hearing no response, we will move on to our next question that comes from Kash Rangan with Merrill Lynch.

Kash Rangan – Merrill Lynch

Hi, thank you very much. Zach, I just wanted to chime in with a question or two. One is that it certainly looks like with the OneWorld product, you have taken the business more towards larger multinational global enterprises. I am curious if the new – and it seems to be pretty big opportunity. I am curious how long it takes for the incremental sales force, the new heads you are adding, I am wondering first of all if you are going to be directing some of these new sales people in that direction. And if yes, how do those sales cycles look like and what kind of partnerships are we going to see from the company and potentially when could we hit an inflection point, because it certainly looks like you’re pretty close to what could be something big? And with SAP pulling back a little bit from DBD and what seems to be lack of any significant announcements from Microsoft in that direction, it looks like you could be on to something, but just wondering how the dynamics play out there in sale cycles, partnership, productivity, et cetera?

Zach Nelson

Yes, we haven’t really seen an enormous extension of sales cycle around OneWorld. Again, we have really had the product into our sales force for well over a year now. So people are very familiar with it. There was a lot of pent-up demand waiting for OneWorld and the capability that when people see it, they want it right away. So that is point number one.

Point number two, we did roll it out to our customer base fairly slowly and part of that was that we knew how to implement customers efficiently and effectively. So we have a great methodology for now getting customers up and running in a multi-subsidiary environment and that was a second big component of the strategy internally.

To your point of partnerships, I think, as more of the world moves to SaaS, you are seeing lots of large SIs and traditional service companies start to really rethink their strategy about the types of applications they are deploying. And I think over the coming months, you will possibly see some very interesting announcements with NetSuite and some of the more familiar names in the systems integration business building practices around NetSuite, but more importantly, in that particular segment of the market around OneWorld. So, your questions are very well put and I think you will see progress on all fronts in terms of sale cycle, new partnerships, and geographic opportunity playing out based around the OneWorld product.

Jim McGeever

And if you listened to Dean Mansfield on the analyst day who heads up sales, he talked about the different sales groups that we have. And certainly a number of the additional heads that we are hiring are targeting larger companies and he is forming a strategic accounts group, which is really going after these larger OneWorld opportunities.

Zach Nelson

And just let me interject one more thing. So, while we are talking about larger companies, it certainly is an effort by which we can move up market. Again, when you look at – you are upper, you look at Asia Pacific, even if you will small or mid-sized companies have this requirement for multiple subsidiary management. If you are in the UK, you are going to sell into France, you are going to sell into Germany, you are going to sell into Italy, you are going to sell into Sweden. Those are all going to be separate subs. So, even your lower end mid-market companies are going to benefit enormously from OneWorld.

Kash Rangan – Merrill Lynch

Got it, thanks. And Jim, one quick question for you. The investments you make in the professional services that are probably cutting into margins in the near term, how should we think about when you hit an inflection point on how the investments you are making today will actually be additive to the combined gross margins in the future?

Jim McGeever

We would not expect the gross margins to be negatively impacted or changed as a result of any incremental professional services or support reasons. What you will probably see is that we expect the gross margins throughout the year to remain about 70% and it should continue on that trend into next year, even as we add the second data center.

Kash Rangan – Merrill Lynch

Thanks a lot.

Jim McGeever

We do [ph] well ramping up especially in support pretty aggressively to achieve the stacked to fit model which we are at, so we don’t need to increase the sales, the support heads as fast as we have been doing.

Operator

We will take our next question from Mark Murphy with Piper Jaffray.

Mark Murphy – Piper Jaffray

Thank you, Jim. The number of customer adds that you gave in the quarter at 400, was that a gross number?

Jim McGeever

Yes.

Mark Murphy – Piper Jaffray

Do you have any feel for what that would like if we looked at that on a net basis?

Jim McGeever

We haven't been giving out the net number. We said we'd do that once a year. The trends are very consistent with where they have been and we talked a lot about on our analyst day about the mix between smaller and larger customers, and how that trend – what was happening with that trend.

Mark Murphy – Piper Jaffray

Okay.

Zach Nelson

In particular, as we talked a little about on the earlier question about sort of the value – just thinking of NetSuite really being based around the size of the relationship with NetSuite, that in the analyst day, Jim put up a slide of those sub $10,000 customers. They accounted for a large number of customers but a very small portion of the revenue. And that is where you see the churn. And we would love to have everyone of those customers being incredibly successful and incredibly happy with NetSuite, sometimes those guys do churn and the sheer number of them is high, but the volume is – the revenue value is very low.

Mark Murphy – Piper Jaffray

Could you also talk about, as you have had an ability to spend some more time digesting OpenAir here, I know it has still been fairly recent, but can you talk about ability for OpenAir to pull you into some of these larger transactions and just maybe what you are seeing in OpenAir that gets you excited about the second half of the year?

Zach Nelson

Well, I will speak to – I am actually in Boston right now with OpenAir and every time I come here, I am pulled into larger transactions. Customers are very excited about this combination of NetSuite ERP and rich services functionality. There is a good product to manage a services organization end to end. SAP solved the manufacturing problem 20 years ago. No one has solved the problem of delivering services and then billing services and tracking services and profitability of services. There is enormous interest. I was in two meetings yesterday with larger customers who are OpenAir customers that are looking at exactly – doing exactly that, adding NetSuite to the mix and in particular, OneWorld to the mix. So, we have been – as I said, we did the acquisition, we are very heartened by the reception we have got in both in the OpenAir customer base well as OpenAir and the services functionality and the NetSuite customer base. The integration, the planning of the integration, and the functionality of integration is right on track and you will see some announcements on that in Q3. So, yes, we are very excited about OpenAir. Now, that said, we have got work to do on the organization. OpenAir has something like six sales people today. So, we are going to bring some of our expertise certainly to the mix here as we look at expanding the sales capability around that product and the combined product.

Mark Murphy – Piper Jaffray

Okay.

Jim McGeever

I want to add something else, OpenAir has actually been brought into larger deals themselves. (inaudible) by NetSuite. Sometimes large organizations who may not have looked at a company the size of OpenAir, now they are part of a much larger organization, have been brought to the table. So, so far, we are very happy with what we are seeing.

Mark Murphy – Piper Jaffray

Jim, one last one. If we look at the adjusted short-term deferred revenue numbers that you have provided on the Web site and just looking at the year-over-year growth there of about 21%, should we think about that as a good bogie for where the business stands or is that – moving forward, should we expect to see something in that range of roughly 20% growth for that metric?

Jim McGeever

We are still going through this transition which we have talked about many times, the multi-year to single year. And if you actually look at the amount of revenue contained within – how many months of revenue is contained with that short term revenue, you have seen that falling and that's really the result of this transition for the multi-year and single year deals. So, taking the straight 20% doesn’t take out the impact of that transition. So, as we saw for the rest of this year through the first half of '09, so work through that. I mean, that’s going to be roughly the range of where I think you’ll see that year-over-year increase. But that doesn't really give you a true picture of the actual growth of the business because of this transition.

Mark Murphy – Piper Jaffray

And then Jim, any sense for – which quarter specifically would we move past that transition period and do you have a sense for what that gross rate would look like at that point in time?

Jim McGeever

It will be towards mid 2009 – perhaps mid Q3 of 2009 we think we should be fully past that transition. Deferred revenue at that point should behave very similar to how it works for other Software as a Service businesses.

Mark Murphy – Piper Jaffray

Okay. Thank you.

Operator

We will go next to Lawrence Petrone with W. R. Hambrecht.

Lawrence Petrone – W. R. Hambrecht

Yes, thank you. Two quick questions, Jim, you went through the impact of OpenAir on the deferred balance. I think you mentioned $161,000. I was just wondering if there was any write-down of OpenAir balances due to purchase accounting? And my other question, Zach, is regarding DTM, I’m just wondering if you can give us an update on that relationship? Were they able to contribute any dollars during the quarter and are there any other developments we should be aware of with regard to you reseller relationships? Thanks.

Jim McGeever

On the acquisition accounting for OpenAir, so basically lost all the deferred revenues that was on OpenAir's balance sheets as of the acquisition date. So we didn’t get to take any of that revenue. None of that will get – then go into future revenues, that was essentially written down as part of the acquisition accounting. But the only thing you should see in deferred revenue are transactions that happened post the acquisition.

Zach Nelson

And in terms of your question about distribution channels, I’d say the strategy has been and we continue to execute on it that we are doubling down on the things that we know work and the one thing that we know works in our model is direct sales. So you’ve seen us increase that, the number of sales people, by about 30% this year and we’re starting to see the success of that as you look at the growth of the deferred. That said, we also have irons in two fires. One is your traditional VAR channel and we’ve had probably the most complete channel program of any software service provider to try to engage traditional VARs in embracing the Software as a Service market model, in particular the NetSuite model. That element of the channel has remained steady at about 18% of billings for several years, and so we have not modeled that accelerating at all. We assume it will continue to be something around 18% of our billings every year. Someday that channel will become greater and that will be the tipping point when customers starts saying, no, I want on-demand, I wanted integrated suites. We don’t know when that will be. I thought it would have been five years ago, but the good news is we have a program, we understand how the channel operates, we understand how to help them make money. So when they are ready to make the transition, there’s going to be one place they're going to come and that’s NetSuite.

With regards to the broader distribution, the second iron that we have in the fire is exactly what you said, broader distribution. In the same way I believe ultimately VARs will kick in, there will be some form of broadbased distribution channel to the midmarket for an integrated suite like NetSuite. BT is a great example of that. We did that deal last quarter and I think both of us are working through trying to make that successful. We have had some transaction volumes through BT, we actually sold OpenAir through – did an OpenAir deal through BT this quarter, so you are starting to see success in that market. It’s going to take investment on both sides to make it work and we continue to do that, and we’ll continue to do that with other broadbased distribution partners around the world over the coming quarters. So, yes, we’ll continue to invest in those as well as doubling down on the things that we know works and that’s direct sales.

Lawrence Petrone – W. R. Hambrecht

Okay. Thank you.

Operator

We will take our next question from Richard Baldry with Canaccord Adams.

Richard Baldry – Canaccord Adams

Thanks. It looks like after two years of sequential pro forma improvement, this is really the first time you slightly de-levered sequentially. Could you maybe talk from a pretty macro perspective about your thoughts on top line versus bottom line and maybe with a view to the fact that in your Q3 guidance you implied that at the sort of a lower in guidance you could de-lever for a second consecutive quarter. So, I am curious about that trend in the business. Thanks.

Jim McGeever

Sure. So, when we announced the OpenAir acquisition on that release, we talked about changing the bottom line trend throughout 2008 as a result of the acquisition accounting. So that – we really don't feel that we’ve changed our bottom line model really just as a result of the acquisition that we gave updated guidance. And in terms of the – we haven't actually [ph] just the first time we have given Q3 guidance, so it's right in line with I think the expectations that are out there.

Zach Nelson

And for the year of course we maintain the guidance, so I don’t really think there has been any change in the guidance certainly we've given for the year.

Richard Baldry – Canaccord Adams

And on the specific line item on the GAAP&A side. Last year, it did peak in the first quarter and fell actually sequentially twice. Does it look like on a dollar basis, leaving percentages aside, it can still decline into Q3 given the scaling of the overall business? Thanks.

Jim McGeever

So, Q1 is always on the G&A line going to be our highest dollar spend relative to last year just given the nature of the order and legal costs that we incurred in the first quarter. We have given guidance we think G&A is going to be 12% to 13% rest of the year and I think that is probably where it is going to end up. We are incurring fairly significant costs as we go through our Sarbanes-Oxley compliance which is what we have to do for the first year as it is always more expensive in the first year than in subsequent years.

Richard Baldry – Canaccord Adams

Thanks.

Operator

And we’ll take our final question from Brendan Barnicle with Pacific Crest Securities.

Matthew Carson – Pacific Crest Securities

Hi good afternoon. This is Matthew Carson [ph] for Brendan Barnicle. Just to clarify in the last question. I remember from Q1 the EPS guidance for the year was $0.01 to $0.04 loss and now it is $0.04 to $0.06 loss and so that is all for the OpenAir acquisition, right?

Jim McGeever

Yes, when we gave the updated guidance in early June related to the – after we did the OpenAir acquisition, we updated our guidance.

Matthew Carson – Pacific Crest Securities

Very good, that was just a final point of clarification there. And then, in some of the proprietary checks that we have done, we have seen a little bit of concern in the mid market maybe add more deal scrutiny or elongating sales cycles or deals being put off. Have you really seen any of that?

Zach Nelson

I think if you just look at our numbers from the account number, average selling price, it has been a very consistent trend with us for quite some time. So, I think what happens with NetSuite is the I think anybody really totally focusing on the mid market. The opportunity is huge. The number of customers that you can address is huge. So while you may see some slowdown in some deal scrutiny and some segments of the market, financial services or construction, just those two whipping boys in this particular downturn, you have enormous opportunity in the, what I call, the fortune 5 million. So you just look at this quarter, 400 new companies added, good average selling price, you never say never, but the numbers seem to tell a little bit different tale at least in the case of NetSuite.

Jim McGeever

We are very important when the companies are biased, we are very important component of their business, so it is always been a heavy scrutinized product. They have always taken the lot of care over making a purchase decision, so I think we have really seen a change in that.

Zach Nelson

Yes, I think that is an excellent point I should have made. I mean when you are talking about changing out your core business management system, you look at it pretty closely in good times and bad.

Matthew Carson – Pacific Crest Securities

Got it. Thank you very much

Operator

Now, it does conclude our question and answer session. At this time, I would like to turn call back over to you, Mr. Nelson, for any additional or closing remarks.

Zach Nelson

Great. Thank you all very much for joining us tonight and for all the questions. As I said, Jim and I will be speaking at various conferences over the coming quarter, meeting with or one on one, and other investors one on one, so we look forward to taking the time to see you and help you understand what is going on at NetSuite a little bit more. So thanks very much and we’ll talk to you soon.

Operator

And that concludes today’s conference. Thank you for participation you may disconnect at this time.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: NetSuite Inc. Q2 2008 Earnings Call Transcript
This Transcript
All Transcripts