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SuccessFactors, Inc. (NYSE:SFSF)

Q2 2008 Earnings Call Transcript

August 6, 2008 8:00 pm ET

Executives

Bruce Felt – CFO

Lars Dalgaard – Founder, President and CEO

Analysts

Sarah Friar – Goldman Sachs

Brendan Barnicle – Pacific Crest Securities

Tom Ernst – Deutsche Bank

Adam Holt – Morgan Stanley

Terry Tillman – Raymond James & Associates

Nate Swanson – ThinkEquity Partners

Richard Baldry – Canaccord Adams

Michael Nemeroff – Wedbush Morgan Securities

Brad Whitt – Broadpoint Capital, Inc.

Brad Reback – Oppenheimer & Co.

Operator

Good afternoon and welcome to SuccessFactors fiscal second quarter 2008 financial results conference call. We have placed all lines on mute, and we'll take questions following prepared remarks. (Operator instructions)

I will now turn the call over to Bruce Felt, Chief Financial Officer of SuccessFactors. You may begin your conference.

Bruce Felt

Thank you, Jennifer, and good afternoon, and welcome everyone to SuccessFactors June 30th 2008 financial results conference call. The primary purpose of today's call is to discuss our second quarter performance.

However, some of our discussion may contain forward-looking statements which may include projected financial results or operating metrics; business strategies; anticipated future products or services; anticipated market demand or opportunities; and other forward-looking topics.

These statements are subject to risks, uncertainties, and assumptions. Accordingly, actual results could differ materially. For a listing of the risks that could cause actual results to differ materially, please see our Form 10-K and latest Form 10-Q filed with the SEC as well as the factors identified in today's press release.

I would like to introduce SuccessFactors Lars Dalgaard, Founder, President and Chief Executive Officer. And I am Bruce Felt, Chief Financial Officer.

Unless otherwise stated, all references to spending exclude stock-based compensation which are non-GAAP measures and reconciliations from non-GAAP to GAAP can be found in our press release. Following our prepared remarks, we'll open things up to you for questions and answers.

Today's call is available via webcast and a replay will be available shortly following the conclusion of the call through Friday, August 15th. To access the press release, supplemental financial information or the webcast replay, please consult our investor relations website at www.successfactors.com/investor.

So with that, let me turn the call over to Lars.

Lars Dalgaard

Thanks, Bruce. Hello, everyone. It's my pleasure to bring you the results from another great quarter of SuccessFactors. We had strong year-over-year revenue growth of 71% and deferred revenue growth of 94% while expanding gross margin and operating margin to the best in years.

We are growing organic revenues two times faster than the average SaaS company with a revenue run rate of over $100 million, and three to four times faster that of any public player in our industry to our knowledge.

Our 2004 global strategy for market domination and revenue and profit diversification is working even in this challenging economy. SuccessFactors team executed another gross margin expansion in Q2, up from 53% in Q4 to 61% in Q1 to 65% in Q2.

In total, this was a 1,200 basis point gross margin improvement since the beginning of the year. Non-GAAP operating margin has been improved 39 full percentage points since the beginning of the year to the best performance in more than three years like we promised you at the IPO.

In Q2 we saw a decrease in absolute dollars of COGS and G&A expenses relative to Q1 due to the productivity and excellent execution of our professional services team and leverage across our G&A functions.

This allowed us to invest in the revenue generating areas of sales and marketing and R&D. Yes, I said R&D. Why is R&D revenue generating? We have proven that we can in a year or two create more sales by creating more new products through R&D investments. To remind you of this, we see more than 65% of new sales come from products that didn't even exist three years ago.

Cash flow used in operations improved 700 basis points from the same time last year. We are very much on track to hitting our cash flow breakeven target of Q3 '09 while building a very strong sustainable growth and cash annuity business.

We had as many upsell transactions as new customer transactions resulting in nearly 450 total transactions for the quarter. This large amount of upsell transactions in addition to our fast new growth we attribute to our high customer satisfaction level, the pace of our new product development, and the speed (Technical Difficulty). Across the business, average deal size continued to improve; across all sales forces, productivity is up and win rates are strong. And finally, pricing remains solid by user, by module, led by a substantial price increase in small business that was successfully introduced during the quarter.

The momentum is really accelerating our business. Looking back, it took us more than four and half years to reach our first one million users on one code base. Today, SuccessFactors at the forefront of leaders in the SaaS market with more than 4 million unique users on one code base up from 2 million at the end of 2006.

In a little more than two quarters of 2008, we have added nearly as many users as we did in all of 2007. SuccessFactors maintains customer retention rates despite this growth exceeding 90% and dollar renewal rates exceeding 100% as it has since inception for the last six years.

Further, on financial performance, today SuccessFactors, I'm very proud to announce has broken through the $100 million mark in recurring subscription base. Using the profitability study summarized in our Form 10-K, that recurring revenue stream represents more than $68 million in annual recurring potential profit.

The immense profitability of this $68 million cash annuity stream is the reason we continue to invest (Technical Difficulty). Few other companies have positioned themselves in a way to be able to deliver such high levels of long-term profitability.

SuccessFactors is aggressively hiring with job requisitions around the world across all functions. At the end of the quarter we had 724 colleagues, and as of today, we have 741. Our very strong management team has been recognized, but even more important truly, is the strength of the teams, two and three and four levels down in the organization.

I'd really like to thank the whole organization for the exceptional execution to-date, and I'm very encouraged by the continued execution. We are very careful in hiring and training them and it is paying off with very strong collaboration [ph], execution, and productivity increases as you saw.

As such, SuccessFactors is raising full year 2008 revenue guidance by approximately $2.5 million, an increase over previous guidance. We're also raising full year 2008 non-GAAP EPS by $0.16 over previous guidance.

SuccessFactors geographic expansion progressed significantly in the second quarter. We have been a global company from the beginning. Truly, the product was used everywhere to start out, but now, with products available in 22 languages, and used in more than 185 countries around the globe.

Europe had its largest quarter in company history with three of the seven largest transactions in the quarter, and 10 deals over $150,000. In Europe, we added new customers in many countries including Hilti in Lichtenstein, TetraPak in Switzerland, General Dynamics in Germany, Société Générale and SKF in France, Cable and Wireless in the UK, Novozymes and Kongsberg in Denmark, and Sky Italia and Navionics in Italy. Our international success are not limited to EMEA as we closed deals across Asia including New Zealand, Australia, Singapore, Malaysia, Vietnam and Korea.

Hilti in Europe, who joins us with 15,000 users in nine languages is a great example how SuccessFactors scales by number of users across multiple geographies. LG Electronics, novel company out of Asia, joins us with 40,000 users on Goal Management, Performance Management, 360, Employee Profile, and three language packs.

Inventory channels and partnerships, in addition to the many partner deals mentioned in the press release, SuccessFactors announced a Q2 global partnership with IBM, which resulted in closing a Fortune 250 company in Q3.

On products during the quarter, we invested heavily in extending our product leadership and continued our innovation with product enhancements delivered across the entire suite. We introduced Professional Edition ULTRA for SMB companies up to 500 employees, includes a powerful new self-service toolset makes it even easier for customers to quickly set up, configure, customize and manage their opponent.

We also advanced the Employee Profile module to serve as what our customers call the employee information hub for their organizations. A lot of employee information has traditionally been stored in a variety of locations, but ease-of-use, consistency or relevancy of this information has been a core challenge in legacy systems.

So, some of our customers, like Gambro out of Europe, are increasingly using our Employee Profile as an interface into employee information across the organization, tying multiple systems into a single highly accessible bi-directional Employee Information Hub.

Finally, this week SuccessFactors proud to announce that we have teamed with Google to bring the power of cloud computing to the existing four million users of SuccessFactors and over 500,000 Google Apps customers, and many more (Technical Difficulty).

The Google and SuccessFactors have now delivered five new generally available integrations between our suite and some of Google's productivity and collaboration tools. Google and SuccessFactors have worked on some very new and relevant applications that we look forward to revealing soon.

Our ongoing collaboration with Google will help organizations increase workforce productivity and performance, demonstrating the value and potential that comes from these two innovation machines.

On professional services in Q2, SuccessFactors Professional Services team implemented 259 go-lives, bringing the year-to-date go-lives up to approximately 540 or more than four per business day. We're impressed on how quickly some of the larger new customers in Q2 went live so quickly.

McAfee, the world's largest security technology company, went live in the quarter with SuccessFactors compensation for 3,600 users in 43 different countries and multiple currencies to tie pay to performance. Smith & Nephew, a global medical technology company deployed Succession Management on our Ultra Platform in several countries in four weeks.

And (inaudible) on the model, of course is upsell. Upsells again comprised 31% of (Technical Difficulty). Here are some examples. JF Hillebrand Group, out of the UK became a customer in Q1 with Employee Profile, Goal Management, Performance Management, 360, Career Development, Succession Management, and Compensation Planning. (Technical Difficulty) in Q2, because of the successful deployment, they grew the number of users across all the original modules and purchased an additional language pack.

Edward Jones went live on Succession Management and Career and Development Planning from SuccessFactors in 2007, totaling over 16,000 users. In Q2, Edward Jones decided to also purchase Goal and Performance Management for 7,500 employees.

Another great story is Cadbury Schweppes, went live with Performance Management and Goal Management in Q1 as we discussed on our prior conference call with 11,000 of its colleagues in ten languages in business units across Europe, the Americas and Asia-Pacific. Cadbury in Q2 decided to implement Succession Management and also Career Development Planning, two different products, for over 8,000 users.

SuccessFactors once again profiled in Fortune magazine and highlighted as a software provider that helps SMBs quote, this is the name of the article "reward stars and lose deadbeats."

A real highlight of the quarter was the amazing global user conference SuccessFactors conducted the first week of June in San Francisco. Thanks to those of you who attended, but those who couldn't make it, the energy was electric. Thanks for being there. We had more than 700 people from over 300 companies in attendance. We had customers showing off their instances, real line frontline customer employees and executives participating on stage, and more than 40 customer presentations.

Due to the overwhelming requests we've received from our customers across Europe, we are thrilled to announce our first user conference there. This supports the investment we continue to make in Europe and will complement the very large sales growth we're seeing of 200% year-over-year.

Bruce, please take us through the financials in more detail.

Bruce Felt

We had a strong Q2. We experienced strength across the enterprise, small business, medium business, and internationally, demonstrating our ability to execute on all fronts, all customer sizes, all geographies, and all products.

Our upsells remain healthy and our customer retention rates continue to exceed 90% while dollar renewal rates exceed 100%. First quarter revenue was $25.7 million, a year-over-year increase of 71% and 10% sequential growth.

On spending, total spend for Q2 '08 was $43.6 million, a 5% sequential increase from Q1 '08. This is the third consecutive quarter where expenses have increased single digit versus a growth of 107% in all of 2007. We are demonstrating expense discipline while continuing to realize market leading growth.

Because of the Greenfield market opportunity and the fragmented competitive landscape, we plan on investing in those areas that will yield the highest return, namely R&D and worldwide sales capacity.

On gross margin, we continued to experience gross margin improvement in Q2 '08 at 65% compared to 61% in Q1 '08 and 53% in Q4 '07 by utilizing the professional services capacity that we hired in the latter half of 2007.

We plan to hire professional services personnel in Q3 and Q4 at a faster pace which is expected to result in gross margins for the next two quarters to be level or slightly lower than Q2, but for the year, we expect it to be at or above the 63% we realized in the first half of the year.

Sales and marketing expense increased sequentially 7% as we continued to hire and build out our sales to maintain our distribution dominance. We expect to continue to expand our sales and marketing expense in Q3 and Q4 above the levels we saw in Q2.

R&D increased by 20% sequentially in order to expand and extend our product suite and to maintain our product and innovation leadership. We continue to believe an organically built solution not only provides the best customer experience, but is also the most cost effective over the long run.

Our R&D resources can focus on innovation rather than the integration of disparate code bases and engineering teams. We continue to realize good financial returns on these investments as shown by the increased contribution of new products. We plan to invest at comparable or higher rates through the balance of the year assuming the returns are there.

G&A expense decreased sequentially by 5% from Q1 higher costs related to our fiscal audit, tax and legal. For the balance of the year, G&A is still expected to continue to be a source of leverage.

For Q2 '08 earnings per share, our GAAP net loss per share was $0.37 and our non-GAAP net loss per share was $0.33, which excludes stock-based compensation expense of $2 million, an improvement from a non-GAAP net loss per share of $0.34 in Q1. We are using 52.3 million weighted average shares outstanding during the quarter.

Next, cash flow and the balance sheet, cash used in operations was $6.4 million, a 47% improvement from Q4 '07 $12.3 million and also better than the $6.9 million cash used a year ago. Q2 experienced a greater cash use than Q1's $4 million as we had discussed during our Q1 results call. As discussed during our last quarterly call, Q2 is expected to be the highest cash use quarter for the year.

CapEx was $2.5 million for the quarter as we increased our commitment to providing our customers with world-class facilities to deliver and protect their information. The majority of the spend was for an additional U.S. data center to further optimize capacity and reduce computing costs.

We reiterate our goal and commitment to become cash flow positive by Q3 2009. Because of the greater than $100 million of highly profitable recurring revenue base of business we have built, we could become cash flow positive sooner simply by limiting growth investment.

Because of the compelling market dynamics and because of the financial benefits that we believe will accrue to us by extending our lead in the performance and talent management space, we plan to continue to reinvest the profits from the recurring revenue stream back into the business, but at a level that does not jeopardize our cash flow positive commitment.

On the balance sheet, total cash, cash equivalents and marketable securities ended the quarter at $105.7 million. Net proceeds from our secondary offering was $27.7 million although the secondary offering was driven by our desire for increased liquidity for institutional shareholders and for an orderly distribution of stock from our historical investors.

We did take the opportunity to increase our cash balances in order to strengthen our balance sheet, which provides additional capital for possible tactical acquisitions, specifically in the areas of technology, content or geographic expansion.

Strong sales resulted in a record quarter for deferred revenue. For business that has been invoiced but revenue not yet recognized, our deferred revenue on the balance sheet finished a record $123.6 million, up 94% from the $63.6 million a year ago and increased $10.8 million from Q1 '08.

We have the largest deferred balance relative to reported revenue than any other on-demand software company that we are aware providing for significant visibility, high quality revenue and a market presence much greater than our recognized revenue imply.

On our outlook, we are initiating guidance for the third quarter fiscal 2008. We expect revenue for Q3 '08 to be in the range of $27.5 million to $28 million, which equates to approximately 66% year-over-year growth.

Excluding the impact of stock-based compensation expense, we now expect Q3 non-GAAP net loss per share to be in the range of $0.35 to $0.37. This estimate assumes an average weighted average share count for the quarter of approximately 56 million shares.

For the full year 2008, we believe revenue is expected to be in the range of $107 million to $108 million, up from our prior guidance of $104 million to $106 million coming into Q2 '08.

Non-GAAP net loss per share, excluding stock-based compensation expense is now expected to be in the range of $1.39 to $1.43, better than our guidance going into Q2 '08 of $1.55 to $1.59. This estimate assumes a weighted average share count for the year of approximately 54.3 million. By all measures, our (Technical Difficulty) was a great quarter.

With that, let me turn the call back to Lars.

Lars Dalgaard

We want to just repeat part of the script that we think was not acoustically heard because of technical issue. So, SuccessFactors is raising full year 2008 revenue guidance by approximately $2.5 million, an increase over previous guidance; also raised full year 2008 non-GAAP EPS by $0.16 which was mentioned over previous guidance.

On the international business, SuccessFactors' geographic expansion progressed significantly during the second quarter. And we've been a global company obviously from the beginning, but now with products available in 22 languages and used in more than 185 countries around the globe.

Europe actually had its largest quarter in the company history, with three out of seven largest transactions in the quarter and ten deals over $150,000. In Europe, we added new customers in many countries across the entire space, from Hilti in Lichtenstein to TetraPak in Switzerland, General Dynamics in Germany, Société Générale and SKF in France, Cable and Wireless in the UK, Novozymes and Kongsberg in Denmark, and Sky Italia and Navionics in Italy.

Our international successes are not limited to Europe as we closed deals across Asia-Pacific including New Zealand, Australia, Singapore, Malaysia, Vietnam and Korea. Hilti in Europe, who joins us with 15,000 users in nine languages is a great example of how SuccessFactors scales by numbers across multiple geographies. LG Electronics in Asia joins us with 40,000 users on Goal Management, Performance Management, 360, Employee Profile, and three language packs.

In addition to the many partner deals mentioned in the press release, SuccessFactors announced a Q2 global partnership with IBM, which resulted in closing a Fortune 250 company in Q3.

On the products side during the quarter, we invested heavily in extending our product leadership and continued our innovation with product enhancements delivered across the entire suite.

We introduced Professional Edition ULTRA for SMB companies up to 500 employees. It includes a powerful new self-service tool kit that is essential for small companies. That makes it even easier for these companies to quickly set up, configure, customize and manage their instances.

We also advanced the Employee Profile module to serve as what other customers call the employee information hub for their organizations. A lot of employee information has traditionally been stored in variety of locations, but ease-of-use, consistency or relevancy of this information has been a core challenge in legacy systems.

So, some of our customers, like Gambro, are increasingly using our Employee Profile as an interface into employee information across the organization, tying multiple systems into a single highly accessible bi-directional Employee Information Hub.

Finally, this week SuccessFactors was proud to announce that we have teamed up with Google to bring the power of cloud computing to the existing four million users in the enterprise of SuccessFactors and 500,000 Google Apps customers, and many more to come from both. Together Google and SuccessFactors have now delivered five new generally available integrations between our suite and some of Google's productivity and collaboration tools.

Google and SuccessFactors have worked on some very new and relevant applications that we really look forward to revealing soon. Ongoing collaboration with Google will help organizations increase workforce productivity and performance, demonstrating the value and potential that comes from those two innovation machines.

In Q2 SuccessFactors Professional Services Team implemented 259 go-lives, bringing the year-to-date go-lives up to approximately 540, or more than four per business day. We're impressed at how quickly some of the larger new customers in Q2 went live so quickly.

McAfee, the world's largest security technology company went live in the quarter with SuccessFactors Compensation for 3,600 users in 43 different countries and multiple currencies to tie pay to performance. Smith & Nephew, a global medical technology company, deployed Succession Management on our Ultra Platform in several countries in four weeks.

Upsells, again, comprised 31% of new business in Q2 '08. I'd like to just explain it with a couple of examples so you understand how that works. JF Hillebrand Group out of the UK became a customer in Q1 with Employee Profile, Goal Management, Performance Management, 360, Career and Development Planning, Succession Management, and Compensation Planning. Immediately in Q2, right afterwards, because of the successful deployment, they grew the number of users across all the original modules and purchased an additional language pack.

Edward Jones went live on Succession Management and Career and Development Planning from SuccessFactors in 2007, totaling over 16,000 users. In Q2, Edward Jones decided to also purchase Goal and Performance Management for 7,500 employees.

Another great story is at Cadbury Schweppes, went live with Performance Management and Goal Management in Q1 as we discussed on our prior conference call with 11,000 of its colleagues in ten languages in business units across Europe, the Americas and Asia-Pacific. Cadbury in Q2 decided to implement Succession Management and Career Development Planning for over 8,000 people.

We were mentioned in Fortune Magazine, where we were highlighted as a key SMB company. The quote of the article was – the title “Reward stars and lose deadbeats.” The real highlight, of course, was our amazing global user conference that we conduct in the first week of June, and thank you to all of you who attended. The energy was truly electric. It was a fantastic time to be there.

We had more than 700 people from over 300 companies in attendance. We had customers showing off their instances, real frontline customer employees and executives participating on stage, and more than 40 customer presentations.

Due to the overwhelming requests we've received from our large growth in Europe, from our long year investment, I think it's been four years now, we're thrilled to announce our first user conference there. This supports the investment we continue to make in Europe and will complement the very large sales growth of over 200% year-over-year.

So, with that, I beg your forgiveness for having to gone back on that, and we go to questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from Sarah Friar, Goldman Sachs. Your line is now open.

Sarah FriarGoldman Sachs

Good afternoon, guys. Good quarter. First, a question around expenses. Bruce, on the sales and marketing line, you've been better that we had expected for the first half of the year. So it seems like you're getting some quite good leverage out of the sales force that you have, and I know you added a lot of heads kind of pre-IPO even. Is there an ability as you look forward, if the environment stays tough, to maybe pare back on some of the sales and marketing hiring? And what would make you decide to do that, to kind of work with what you have rather than feeling like you had to add a lot more heads right now?

Bruce Felt

We are getting a lot out of what we have. I mean, as you know, we hired aggressively in 2007, and we made it pretty clear we could let that ramp and we would still see very strong growth, and that in fact has happened. But we do see some market opportunities to be as big, if not bigger than ever, and we still are committed to extending our lead in the space. We continue to roll out new products to more customers and are still completely Greenfield and totally fragmented. So, we're very interested in making sure that we keep dominance out there, so we are going to hire reasonably aggressively, but still within the context of the guidance that we've given. And because we've done so well in cost of sales and G&A, we've actually just freed up the capital to be able to deploy it in that area without really an adverse impact on the guidance and our plans for the year. So we don't see a reason to slow that down at this point, but we have demonstrated we certainly can get a lot of leverage if we so choose.

Sarah FriarGoldman Sachs

Got it. And then I just want to make sure I heard you correctly. On the gross margin side, you said that gross margins would be lower organic in Q3 and Q4 from where it's a kind of peak you hit in Q2. Is that right?

Bruce Felt

Yes, we plan to continue to hire in professional services to a greater level than what we've just on, but not so much that we think will dip below the 63%.

Lars Dalgaard

So still be an improvement for the year.

Sarah FriarGoldman Sachs

Got it. And so, then, Lars, I mean maybe a question for both of you then, strategically, I mean why the need to keep hiring in professional services which tends to be a much lower margin business? I mean, you guys are a software company at heart. And as you're able to strike these relationships with big companies like IBM, I would think that's a much better way to go to market than kind of doing a lot of the servicing yourself.

Lars Dalgaard

Yes, it's very simple. We're just growing very fast, so we need a lot of people everywhere and we can't only rely on those partners. We're growing globally, and so we need our own expertise. We've created a revolution here. We're going into a brand new market and nobody has ever done it before. And so, actually, IBM and others do not have the experience of doing it on an application like this. We're partnering with IBM to extend that facility and be able to do it broader. But we need to have the expertise and the knowledge that in all these regions globally, and we need to invest behind that. And as we've said before, it's actually a very profitable business for us. It's just not stated very well from GAAP because you defer every single point of the dollars over the total item of the deal we take the full expenses up. But you'd be surprised how incredibly profitable this is for us. We actually like the business. But the percent of new bookings has actually been steady since '07, beginning '07, have been exactly the same percentage and we're very excited about that business. And the customers like the expertise and the knowledge that we bring to the implementation. Obviously, the majority is still upsell is build software. And that's why we have this $100 million recurring base now. But we like to be close to our customers. We'd like to be able to control our future and then extend it with great partnership across the globe like we've done.

Sarah FriarGoldman Sachs

Got it. One more, and then I promise to leave and shut up. On your use of cash, you now have cash of $100 million. You've started to see some acquisitions go on in your space kind of a quarter ago. Is that – would you think about inorganic growth rather than just be organic growth, or it's pretty much you're still comfortable with what you're doing internally that that's where you're still focused?

Lars Dalgaard

Yes, I think sometimes companies acquire when they have a problem to fix, and in our case, if it didn't broke, don't fix it. We're growing. We're growing four times as fast as others in this industry. We don't really feel we need it. But, Bruce, (Technical Difficulty) on this topic?

Bruce Felt

But we do – we are looking at – we'll call it more tactical acquisitions. It's very consistent with organic growth that's technologies that are really consistent with our roadmap. It's content that we kind of really just plug into our framework and quite easily sell and it adds a lot of value, and possibly, some geographic expansion. But we believe that's all very consistent with our organic growth strategy.

Sarah FriarGoldman Sachs

Got it. Great. Thank you very much.

Bruce Felt

Thank you.

Operator

Our next question comes from Brendan Barnicle of Pacific Crest. Your line is now open.

Brendan BarniclePacific Crest Securities

Great. Thanks so much, guys. Lars, I think last quarter, you gave us the breakout of non-performance management deals in the quarter, you gave us upsell. Did I miss that metric or do you have that? I think you had it on like new customers maybe last quarter.

Lars Dalgaard

No, we didn't share that. You're right. And there's not been any big change. It's pretty much the same as it was last quarter.

Brendan BarniclePacific Crest Securities

I think last quarter like 65% were non-performance management. Is that right?

Lars Dalgaard

Yes, that's right. And it's just a little more of a tilt to non-performance management. Performance management, and in Goal, still growing very explosively, but the power is coming from all these other applications that are being launched successfully, all these other content and all these other services. And so, that's giving Performance and Goal Management a serious battle for its money.

Brendan BarniclePacific Crest Securities

Perfect. And Bruce, just on the deferred revenue side just the way we'd model it. Short-term was better than we expected. Long-term was a little bit lighter. Any change in deal terms or deal durations that might be affecting that long-term?

Bruce Felt

No, the overall mix was pretty consistent across professional services, deal size, length. So there's actually nothing unusual that's really happened there.

Brendan BarniclePacific Crest Securities

And of balance sheet any change?

Bruce Felt

Backlog continues to grow. We haven't – we aren't disclosing the exact number, but it does continue to grow and we'll update everybody in Q4 on the exact number.

Brendan BarniclePacific Crest Securities

Perfect. And then can you give us any guidance on other income? Now that you've got this additional cash on hand, what we should expect for the rest of the year?

Bruce Felt

It should be pretty consistent with what you're seeing this quarter. I mean, unless interest rates change dramatically our cash balance obviously did go up, so we will get more interest income from that. But that's the real driver in that – in the interest area.

Brendan BarniclePacific Crest Securities

So that's 730, 750 level is maybe what we should model quarterly?

Bruce Felt

I think that's a reasonable modeling number to use.

Brendan BarniclePacific Crest Securities

Perfect. Great. I'm done. Thanks, guys.

Bruce Felt

Thank you, Brendan.

Operator

Our next question comes from Tom Ernst of Deutsche Bank. Your line is now open.

Tom ErnstDeutsche Bank

Good afternoon. Thanks for taking my question.

Lars Dalgaard

Thank you.

Tom ErnstDeutsche Bank

Following up on the gross margin, the performance there was just stunning. It sounds like from your earlier comments this wasn't a revenue mix shift. Is that correct? And if so what mechanically drove the big expansion gross margin? Is it utilization on the pro services side or capacity utilization on the hosting cost side?

Lars Dalgaard

It's all the above, but in particular, the team has really executed. We've been talking a lot on earnings calls on the systems we developed internally to do professional services quicker, smarter and at less cost. And so, just phenomenal management there and we feel we're doing a bit of a sort of Toyota-like breakthrough in how you deliver software. And we've just been able to do it extremely affordable with a great profit – back to Sarah's question. And that's why we were rewarding these people on the call by thanking them for the execution they've done. And then the cost per computing, we've continued – the team there has executed on finding new places where we've been able to get the cost computing significantly down, and then so we continue to do that and getting more and more profitable on all lines. But it's just completely understated by the way GAAP works (Technical Difficulty) yes, we were very excited by that improvement, and then as you've heard, we're continuing to promise improvement for the year, maybe not completed to the extent, but we're very impressed with everybody's doing there.

Tom ErnstDeutsche Bank

Good. And shifting gears, it seems by the strength of the performance and your outlook that you must not be seeing overall macro weakness that I think some of the market fears for your business. But the question is if you look at the details, do you find any hints of the macro weakness some people fear or perhaps in pricing, on renewals, or closure rates, how long it takes to move the deals to the pipeline, anything you can see?

Lars Dalgaard

There's no doubt, Tom, that we would be growing a lot faster in a different market if there wasn't this trouble at this point is, but we've really built up a very strong sales execution machine. And so, we feel extremely comfortable with the guidance we've given and the way that the team is collaborating and executing on that. Is it easy? Of course, not. It's a lot of hard work. But this team has been together for a long time. They're executing, the new reps are really coming in to their own, the ramping is happening. The customers were able to implement in more or less the same times, and the products are substantially strong, and able to beat upsell to all these accounts. So, we feel that this strategy in all the geographies. And then, when you're in a situation where everybody is doing their job, and then in a region like Europe, goes above and beyond, then you're in good shape.

Tom ErnstDeutsche Bank

Thanks again.

Lars Dalgaard

Thank you.

Operator

Your next question comes from Adam Holt of Morgan Stanley. Your line is now open.

Adam HoltMorgan Stanley

Good afternoon, guys, and congratulations on the quarter.

Lars Dalgaard

Thank you, Adam.

Adam HoltMorgan Stanley

So I had a couple of questions about customer adds and average selling price trends. If you look at the new customer adds, it was actually down a little bit sequentially, but you had a real strong quarter, it looked like, in terms of average selling prices. On the average selling price increases, is it still largely driven by the trend towards larger seat number of deals, or have you seen a material change, in the attach per deal from a product perspective? And I guess the second question there is has the trend towards larger deals changed the linearity in the quarters at all?

Lars Dalgaard

Yes. I think first (Technical Difficulty) we're pretty excited that it's total customer growth is 83% year-over-year. So that's kind of exciting. We're over 2,140 now. And we have been blessed with seeing really deal sizes across the board go up, and price per seat per module has gone up. So that's been truly because of the strength in the implementation and the brand awareness that we have created.

Bruce Felt

Yes, we also shifted the small business up in size as far as the target goes in mid-up, and then our enterprise just continues to execute extremely well and they are just able to get larger and larger deal sizes. And at the same time, our pricing – and back to Tom's question our pricing, has held up extremely well. In fact, it was almost one of the best quarters that we ever had. So, put all that together, the deal sizes are getting larger and we think that's good overall for the business.

Lars Dalgaard

Yes, I saw six clients on the East coast and the South on Friday and on Monday, and it was just apparent how there had been some competition and they had completely dumped the pricing. But we've been able to sustain our pricing which was way above, and it simply is because buyers of these types of applications today know that it's going to damage their entire career if this gets screwed up. And so, they go back to references and the depth of the references, the scope of the references, the geography, and specifically, deal to execute globally with all these types of applications, these languages, nobody has anything that comes close to that. And that's where we were able to get the pricing that we can get consistently.

Adam HoltMorgan Stanley

And if I can just ask a follow-up on pricing, it sounded like your comments, Bruce, there was a price increase in the SMB market. Are you comfortable sharing what the magnitude of that price increase is? And maybe walk us through where you are in terms of actually rolling that out to the customer base.

Bruce Felt

We specifically – we've generally been increasing prices across the board throughout the end part of '07 and even into '08. Specifically, we rolled out a very large price increase in the small business. I'll give you order of magnitude greater than 25% and it was very well received. So, that's been very strong. And what's also been extremely strong in this step we look at carefully, and this feeds into why we're aggressive in investing in R&D is to price per user per module has continued to be very strong. That means, we introduce new products and to get the same pricing as our historically strong product. This is why we have extremely aggressive posture with respect to investing in R&D, getting more products out there because we're able to sell them and get good pricing for them.

Lars Dalgaard

That's why we shared with you this time that, yes, there is very strong customer growth last year and in the aggregate, but we also do as many, if not more, (inaudible) within this client base. We mentioned that to you the 450 because we think it's quite substantial and maybe an important way for you to understand our business. We couldn't do that without all these new innovations. There's one – you could, just in terms of number of seats. But how exciting to actually do number of seats upsell as well as product upsell, and not just be a one trick pony.

Adam HoltMorgan Stanley

Terrific. Thanks for your help.

Lars Dalgaard

Thank you.

Operator

Your next question comes from Terry Tillman of Raymond James. Your line is now open.

Terry TillmanRaymond James & Associates

Yes, thanks guys for taking my questions. Congrats on the quarter.

Lars Dalgaard

Thank you.

Terry TillmanRaymond James & Associates

Lars, in terms of the IBM comment, you mentioned you actually closed the deal on 3Q. Was that deal just kind of an opportunistic early deal success? Or is the pipeline actually kind of maturing quickly and we could see that is maybe an upside driver in the second half of '08, or is it more of an '09 kind of phenomena?

Lars Dalgaard

Well, IBM is an obviously fantastic global company and that they've been very serious about HMS [ph] for a long time. And so, our global approach matches. I'm leaving for Japan tomorrow and I go to Singapore and to China and to Hong Kong. I think that what you'll see is that we've got some real deals. And I'm meeting with all of their people; my other team members are across the globe. And we're really warming up to this collaboration. We're taking it very serious and everything from a product side to implementation as was mentioned, and specifically, in growing both of our businesses not just cross selling, which is a great opportunity; but like this deal, brand new, growing our businesses together. And this is a very exciting deal we're able to do together. Very reputable company and we're very excited to serve.

Terry TillmanRaymond James & Associates

And then just a follow-up question. I think the question earlier in terms of the success with the other modules. In the quarter, is there anything resonating and/or in your pipeline in terms of one that really stands out, whether it's succession planning or the compensation or employee profiling? Does one seem to be an outlier compared to the other ones, or they're all kind of balanced in terms of the demand? Thank you.

Lars Dalgaard

You'd be surprised at how balanced they are. Employee profile is obviously a very new product, so it can't keep up in volume, in dollars, in units yet, with the others that – in our world, beginning to become old because they're three years old. But both Succession and Compensation are extremely strong products, and it's exciting that it allows us every time to go into deal where they can just buy the one product. They don't have to buy the platform. They can start out with Succession, and then to have success which seems like they have in most cases, then we're able to go with some of the other opportunities. And that's how it works for us. But both Succession and Compensation are extremely strong products for us that we don't really see to get serious combination – competition in that combination of products.

Terry TillmanRaymond James & Associates

Thanks for taking my questions.

Operator

Your next question comes from Nate Swanson from ThinkEquity. Your line is now open.

Nate SwansonThinkEquity Partners

Hi, and congrats on the quarter.

Lars Dalgaard

Hi, Nate.

Nate SwansonThinkEquity Partners

Just quick question on seasonality. It seems like in the past, the selling environment, second half of the year has been more favorable than the first half. I'm wondering, as you look through your pipeline, do you see a similar trend this year, and if so, why or why not, I guess?

Bruce Felt

Yes, it's been. We've had very strong Q3s and Q4s, obviously, greater than Q1 and Q2s, and we don't see any difference this year. So, Q3 is stronger than Q2, and then we have great Q4s. Last year was 40% of the business. And so, we do see strong Q4. That's when people are already looking at buying our products.

Lars Dalgaard

But, in terms of controlling your aspirations for us, obviously, there is vacations in Q3. We basically always are looking to make sure that we're careful about this, but we feel strong – lot of large numbers plays in, but we feel strong.

Nate SwansonThinkEquity Partners

I'm just wondering how does that play out now that you have to draw broader product offering as you go back into your installed base in Q3 and Q4. And I guess how does that trend with seasonality as well? I mean, do you think that's an additional upside kicker this year?

Lars Dalgaard

Particularly, I think the kicker is that the reps are really collaborating in the field with professional services and with a whole legion, machine and product marketing team. We're just getting very confident in going in with this. You have to remember this is still of evolution; nobody else has brought this out to this extent. SAP and Oracle combined don't have as many customers on these types of products, these business applications. They obviously have – the HMS [ph] side, but they don't on these business applications. And so, it's new territory for us, this scale, and it's exciting because it's working and we can see reps getting ramped very quickly and being successful in brand new territory. So, I think there is an opportunity to have that kicker, but the biggest kicker is just real people getting ramped and being successful. We're able to attract exceptional talent. I mean, some of the people we hired this last week are just blowing me away, some of the best people that I've ever worked for at Siebel, Oracle, SAP globally, and they want to come over here and change the way the world works.

Nate SwansonThinkEquity Partners

And then just going back to the gross margins, obviously you're seeing real nice efficiencies there. I was wondering, Bruce, is it possible to break out headcount expense as a percentage of your COGS? Or I guess I'm just wondering how much of that is variable versus more infrastructure?

Bruce Felt

Yes, we haven't broken this out specifically before other than to say about two-thirds or 70% of it professional services as the main cost driver. I mean, the next largest is the customer service group. And lastly, it's really the data center and then operations. We just have a very scalable, well architected data center and it's just not that expensive to run. So that's the order of kind of the cost structure that goes into the COGS.

Lars Dalgaard

Yes, I mean, we did no CapEx last quarter, and two and half (inaudible) this quarter.

Bruce Felt

And two and half was really just building a lot of security, redundancy and setting ourselves up to have a lower cost computing center.

Lars Dalgaard

So, net run rate for the year, you're seeing practically no CapEx compared to other companies.

Nate SwansonThinkEquity Partners

And then just I guess a follow-up on the two big deals that you signed in Q1. Have they gone live now? And I guess how do you feel about how those deals are being deployed and customer success stats?

Bruce Felt

Yes, I mean I've personally talked to one of them. One of them we have executive sponsors here. One of my sponsors – to quote them it was the largest of fun that was ever done on time in the history of that institution. So, yes, it's live.

Nate SwansonThinkEquity Partners

All right. Great. Thank you.

Operator

And our next question comes from Richard Baldry from Canaccord Adams. Your line is now open.

Richard BaldryCanaccord Adams

Thanks. Could you talk a little about the types of resources that both yourself and IBM will be putting into the partnership in terms of marketing or sales so we get a magnitude of the effort? Thanks.

Lars Dalgaard

Thank you. We haven't really gone live with that yet, and it's a developing relationship. There's very close connection all the way. We had connections all the way up the pipe. At IMB, the people over there are very generous and introducing us to all the right people whether it's in product, professional services or whether it's in go to market, and so, we're just mobilizing and then taking this investment very serious. I prefer not to discuss any more details at this point in the equation, but when both teams are comfortable, we will definitely announce more of the things we're doing.

Operator

Thank you. Our next question comes from Michael Nemeroff from Wedbush Morgan. Your line is now open, sir.

Michael NemeroffWedbush Morgan Securities

Hi, thanks for taking my question. Nice quarter, guys.

Lars Dalgaard

Definitely. Thank you, sir.

Michael NemeroffWedbush Morgan Securities

Of the 65% plus of the non-performance product sales in the quarter, can you tell us which ones specifically? Was recruiting a big product? And could you tell us how that one is working? Then also, could you tell us if you're seeing any benefit especially with recruiting from the Taleo Vurv acquisition?

Lars Dalgaard

Yes. One that will actually surprise you is that 360. 360 was a very big sell for us. It's an old favorite. And we sort of left it little bit alone, but it's a very strong, robust and hard product to build. It's not been done very well by anybody. It's a very popular product, in general, for many years ago. But, we really introduced that and wired inside of the application, so it ties into our dashboards a lot more. And so we've been able to get a nice stream out of that. Other than that, for sure, Compensation and Performance – excuse me, and Succession are the bigger ones as was mentioned earlier. But recruiting is not quiet, and nor is employee profile. Career development and planning has been really successful lately. And so, we're seeing across the board actually a pretty nice sort of pie chart of distribution here.

Michael NemeroffWedbush Morgan Securities

Also, Taleo mentioned on their conference call that they were developing an SMB performance management product. Could you tell us if you're seeing them more on the sales cycle side in terms of the large enterprise currently? I know it's a new product for them. Are you seeing them at all? And then also how do you feel about them coming after the SMB market with performance management?

Bruce Felt

Right. They're going into SMB market, so, if the same applies, the SMB that we saw on enterprise, that means, we won't see them at all. So, frankly, the only time we hear about them is when we talk to you guys, otherwise, it's quite on the home front.

Michael NemeroffWedbush Morgan Securities

Just following up on some of the previous comments. You mentioned about the company is hiring – a couple of months ago, you let go a big number of people. Can you tell us how – what kind of an impact that has on morale? And can we expect that the bottom 10% of performers of the company each year are going to continually get cold?

Lars Dalgaard

Yes, I think – I invite you to come in and walk the floors here and then just hang out like the way we did at our user conference. We had no restrictions like other companies do. Every single person that's involved with the company on the analyst side or buy side was allowed to walk around and meet with all employees and all customers. We're a very open company. I don't have an office. I sit out in the open with everybody else. I have the same size desk, so does Bruce; so does every one of our execs. I think you'll find that the energy and the morale of this company is above what you see in any normal company, and may be in the top 1% of the world. It's a quite unique place to work. We have no (inaudible) and we have true collaboration. We have a meritocracy and people love to work here. But it's not for the faint of heart and it's not for everybody. It's a tough place to work, but it's a lot of fun to work here. And it's the people who have been in sports have been successful or weren't successful in sports or want to be successful and really want to kick butt. That type of people we attract. We've talked about being something like a Buddhist Navy Seal. We're nice to people but we kick (inaudible). And that's not for everybody. And so, I wouldn't say that we had a big clearing out. We definitely were very clear on where we had made some false hiring and that happens for all companies. The difference is we're not afraid of figuring it out and doing something about it. But I have been very impressed with how we have recruited in the last six months and we've used some of our products for it, and we've spent a lot of time in the profiling and we've spent a lot of time getting it exactly right and being much closer on boarding. And so, I like the pace with which we're hiring. It continues to keep us way ahead of everybody, and it allows us to really execute globally which has been a strategy from the start.

Operator

Thank you so much. We have our next question from Brad Whitt from Broadpoint Capital. Your line is now open, sir.

Brad WhittBroadpoint Capital, Inc.

Hey, guys, thanks for taking my questions. Just a couple of quick follow-ups. Lars, you meant – you talked a little bit about large deal activity. I didn't get all those metrics. I don't know if you can go through that and give us little more color maybe how compared to last quarter. I know you had two very big those last quarter. Did you have anything comparable this quarter?

Lars Dalgaard

Yes, we actually did. I mean this is a solid quarter across the board. We basically had, I think it was six million dollar deals which is, of course, extremely exciting for us. And across the board, we had – but it wasn't only in the enterprise. It's just exciting to have that many million dollar deals. And then, that's of course total contract value. In addition to that, we also had over, I think it was – let's just look at the data here. Yes, pretty similar distributions what we had, a little bit of growth, but over 30 deals over $250,000, over 13 deals were over $500,000.

Bruce Felt

Let me add. We did not have the mega deals that we had in Q1 just to be clear. So the distribution of everything else looks strong and trended right, but no mega deals and that's $1 million plus in first year invoicing that were calling the mega deal.

Lars Dalgaard

So only six million – six – 1 million in total contract value plus.

Bruce Felt

And that's consistent with what we've done before just no reliance on super big deals.

Operator

Thank you. And our final question comes from Brad Reback from Oppenheimer. Your line is now open.

Brad RebackOppenheimer & Co.

Hi, guys. (Technical Difficulty)

Lars Dalgaard

Hi, Brad. You're a little bit wobbly there.

Brad RebackOppenheimer & Co.

(Technical Difficulty)

Operator

I'm sorry, sir, your audio is really, really bad. We are unable to understand.

Brad RebackOppenheimer & Co.

Can you hear me now?

Lars Dalgaard

Little bit better.

Bruce Felt

Brad, you can try send me an e-mail and I can read it out loud if we can't get through here.

Lars Dalgaard

You sound like RoboCop.

Brad RebackOppenheimer & Co.

It's not a big deal. I just wanted to (Technical Difficulty)

Lars Dalgaard

International? Go for it.

Brad RebackOppenheimer & Co.

(Technical Difficulty)

Lars Dalgaard

So, the percent of international revenue this quarter was bigger. But I would say it was not bigger to degree where you should have any fear about other businesses. The other businesses were extremely strong. But it's exciting for us that this investment we've been making for many years is paying off.

Well, I think we're coming to a close here on the time that we've allocated. I just want to thank everybody as does our entire team for the execution that you help us do here. I want to thank Wall Street for the confidence in us. And we look forward to presenting in the next quarter. Thank you very much.

Operator

Thank you. And this concludes today's SuccessFactors conference call. You may now disconnect.

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Source: SuccessFactors, Inc. Q2 2008 Earnings Call Transcript
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