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Callidus Software Inc. (NASDAQ:CALD)

Q2 2008 Earnings Call Transcript

July 29, 2008 4:30 pm ET

Executives

Ron Fior – SVP of Finance and Operations, and CFO

Leslie Stretch – President and CEO

Analysts

Chad Bennett – Northland Securities

Mark Murphy – Piper Jaffray

Kevin Liu – B. Riley and Co.

Ariel Sokol – Wedbush Morgan

Ted Ketterer – TK Associates

Gregg Speicher – Moss Creek Capital

Operator

Good day, ladies and gentlemen, and welcome to the Callidus Software second quarter 2008 earnings conference call. My name is Sylvana, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's call, Mr. Ron Fior, Chief Financial Officer. You may proceed.

Ron Fior

Thank you. Welcome to Callidus Software's second quarter 2008 conference call. With me on the call today is Leslie Stretch, President and CEO of Callidus Software. Shortly after the market closed today, Callidus issued financial results for the second quarter of 2008. The press release was posted on the wire and is available on our website at callidussoftware.com.

We would like to remind you that during the course of this conference call, we will make forward-looking statements, including predictions and estimates. Those statements, including statements regarding future revenues, on-demand bookings, future expenses, sales and marketing expectations and strategies, product development, and strategic partnerships, involve a number of risks and uncertainties.

Actual results may differ materially from any future performance suggested in our forward-looking statements. We refer you to the company's Form 10-K for the year 2007 and Form 10-Q for the first quarter of 2008 on file with the SEC for important risk factors that could cause actual results to differ materially from those contained in any forward-looking statements. We expressly disclaim any obligation to update this forward-looking information.

On today's call, Leslie will begin with comments about our overall business and financial results, and then I will discuss the financials in greater detail. We will conclude with the question-and-answer session. With that said, I'll turn things over to Leslie.

Leslie Stretch

Thank you, Ron. I’m going to discuss four things on this call today; our Q2 2008 financial highlights, some of our Q2 customer wins and other business highlights, a bit about our product direction, and our outlook and focus on recurring revenues and profitable growth.

Starting with Q2 2008 financial highlights. We are pleased with the progress we are making in our transformation as a Software-as-a-Service recurring revenue based business. Our second quarter results reflect positive momentum in key areas of our on-demand strategy. The net new Annual Contract Value, ACV, of on-demand bookings in the second quarter was $3.3 million, up 200% from the second quarter of 2007. After just two years of offering our solutions on demand, we now have 55 customers generating cumulative annual contract value of $23.5 million and accounting for over 63,000 payees.

Subscription and support revenues for the second quarter were $10.1 million, an increase of 68% over the second quarter of 2007. Recurring revenues as a percentage of total revenues continue to grow and now comprise 43% of our total revenues. I'm pleased that the gross margins on our Callidus on-demand subscription revenues rose to 45% in the second quarter, up from 22% in the first quarter of 2008. Our recurring revenues in on-demand gross margins are ahead of where we expected them to be at this point.

As we stated on our last two earnings calls, due to the transition in our business towards Software-as-a-Service, we expect our perpetual license revenues to be lower in 2008 compared to 2007. Our second quarter perpetual license revenues reflected this shift. Second quarter license revenues were down 74% to $1.9 million as compared to the same quarter last year. Our second quarter license revenues, excluding two transactions booked in the quarter, amounted to $2.7 million, for which we recognized revenues in the first two weeks of Q3 2008.

Services and other revenues for the second quarter were $11.5 million, down 13% from the second quarter of 2007. We have found that we are able to get on-demand customers live on our solution much more quickly than on-premise customers. And we have seen a reduction in our services revenues principally as a result of the shorter implementation projects. We will place substantial focus on the gross margin contribution from services as we go forward. Total revenues for the second quarter were $23.5 million, down 12% compared to the second quarter of 2007.

I'm pleased with our disciplined management of operating expenses. GAAP operating expenses were $13.9 million in the second quarter, down 7% from $15 million in the second quarter of 2007 and down 5% from $14.7 million in the first quarter of 2008. Second quarter GAAP operating expenses included $1.6 million of stock-based compensation as compared to $1.3 million in both the prior periods.

Our GAAP net loss for the quarter was $4.7 million or $0.16 per share compared to GAAP net loss of $2.8 million or $0.10 a share for the second quarter of 2007. Cash and investments totaled $48.7 million at June 30, 2008, and I'm pleased that we added $6.5 million of cash in the quarter.

Let’s turn to Q2 customer wins and some of the business highlights. With 20 on-demand and on-premise transactions, our deal volume in the second quarter was strong. As our on-demand business is growing, we have expanded our footprint in the small and mid-market segments of companies with 200 to 2,000 payees. In the sector, our second quarter wins included Concentra, WW Technology, AvMed and Ther-Rx, which was closed through our pharmaceuticals resale partner, IMS.

We also added some large on-demand customers in the second quarter, including brands like Hyatt and NuVox Communications. We believe we are the only on-demand sales performance management solution that is programmed to scale for customers 2,000 payees and upwards. Our existing customers that are on older versions of our on-premise products continue to benefit from converting to our on-demand solution.

In the second quarter, we sold several on-demand conversions, including Bank of New York Mellon and Cadence. Our on-demand customers represent a variety of industries, including insurance, pharmaceuticals, banking, communications and media, and high tech. We believe that we are the unequivocal leader in sales performance management on-demand space. We are larger and growing faster than any of our competitors.

Turning to our on-premise business, we had some significant wins in the second quarter. We closed business with companies such as Computer Associates, WellCare, St. Jude Medical, and Medtronic. We are particularly pleased with our leadership in the telecommunications sector. Our second quarter in telecommunications included Orascom in Pakistan, SFR in France and Ventelo in Norway. Additionally, working through our Latin American reseller, CIS, we signed business in Brazil with Vivo, one of Latin America's largest mobile providers. We now have over 35 international telecommunications customers. The continued attraction of such great brands to Callidus proves that out customers recognize we have a solution that both saves and makes them money.

Some other business highlights. We launched an offshore center in Hyderabad with our partner Sierra Atlantic in the quarter. And we are pleased with how quickly the operation has become functional. We are augmenting our engineering, technical support, and consulting functions through the center. We have already seen real benefit in product development area such as the offshore team that played an active role in developing Callidus Plan Communicator, our first native salesforce.com application, which I will discuss in more detail shortly. The Sierra Atlantic team will play an important part in future product developments.

Another highlight in the quarter was our addition to the Russell 2000 Index. We also were ranked fourth in CIOZone's Surging 60 list of fast-growing software companies. We expect these two developments to boost awareness of Callidus and our sales performance management solutions.

Let me just talk a little about our product direction. Our transformation to a Software-as-a-Service business has significant implications for our product roadmap. We have an exciting and aggressive product strategy that is focused on multi-tenancy, real-time and mobile device reporting web services and rich easy user interaction. The overarching goal is to offer solutions that are easy to procure, quick to implement, and easy to use.

A quarter ago I told you about the Scrum development methodology that we had adopted. We are seeing expected results of this methodology through more rapid availability of new products and accelerated delivery of enhancements. In the coming week, we will release Callidus Plan Communicator, which is our first product built on top of salesforce's platform-as-a-service force.com platform.

Callidus Plan Communicator will be available for self-service download from salesforce.com's AppExchange online marketplace. As a native salesforce.com application, Callidus Plan Communicator will provide salesforce.com's large customer and user base a seamless and integrated way to deliver compensation plan documents throughout the organization and to manage the plan sign-off and approval process electronically with robust workflow capabilities.

Callidus will be one of saleforce.com's early adopters of Salesforce Checkout, which is the billing system for salesforce.com's partner applications that can be purchased on the AppExchange. In the fall, we will deliver Callidus Pervasive Performance Suite, which is a multi-tenant solution set that expands our performance management capabilities from the sales organization to the entire company.

Central to the Callidus Pervasive Performance Suite is TrueTarget, a new product offering that provides robust objectives and bonus management functionality for all employees, not just sales people. We are increasingly seeing companies pay variable performance-based compensations and on sales employees such as call center agents, client services staff and marketing professionals.

TrueTarget will incorporate the powerful rules and calculation engines of TrueComp, along with sophisticated workflow and analytics to enable line managers and executives to effectively manage pay-for-performance for all employees. The Callidus Pervasive Performance Suite also incorporates a multi-tenant version of TrueComp web services, real-time capability, and mobile reporting capabilities.

Let me just talk about the outlook and focus on recurring revenues and profitable growth. I'm pleased with the progress with our transformation to a recurring revenue based business. As noted previously, recurring revenues comprised 43% of our total second quarter revenues. Entering each quarter with a large amount of revenues already on the books enables us to be much more effective in driving towards profitability and to plan our investments.

As I mentioned earlier, the growth of our Software-as-a-Service business has impacted the amount of services revenues that we generate. We believe that services revenues have decreased for reasons that are beneficial to our customers. And we will manage services gross margins carefully.

The bottom line though is that we are able to implement our on-demand customers twice as fast on average than on-premise customers, resulting in a lower total cost of ownership and faster return on investment for them. Over time, for our on-premise business, we expect to adopt a term license subscription-oriented model in place of perpetual licenses. Doing so will enable our customers to procure our software for less money upfront, which we think will help accelerate the sales process and lead to more deal volume.

On-premise, term license revenues will offer another source of recurring revenues, factoring directly into our initiative of predictable, consistent quarterly results. We still require certain amount of perpetual license revenues to meet bottom line goals at the moment, but we expect to transition to term license model in the first half of 2007 [ph]. We have been laser focused on managing expense, and our results over the last two quarters have demonstrated our efforts. For the first half of 2008, we spent almost $3 million or 9% less than we did in the first half of 2007. We are very committed to maintaining a prudent cost structure.

Now, let me turn the call back over to Ron to go though the financial details in more detail.

Ron Fior

Thanks, Leslie, and good afternoon everyone. Our Q2 results continue to demonstrate how far we have come in the transformation to a Software-as-a-Service business. Our recurring revenues made up of subscription and support services have grown nearly 70% from the prior year. Our on-demand business experienced its second quarter of positive margin, almost doubling the margin percentage from Q1. We expect the contribution from recurring revenues to continue to grow strongly. I am also very pleased with our efforts to control cost throughout all areas of the business. These efforts have contributed to increased on-demand and services margins and a significant reduction of operating expenses over the prior year.

Now I'll walk you through the numbers in more detail. Unless I mention otherwise, the comparative percent increases or decreases are as compared to the same period the prior year. Let’s start with bookings. During the quarter, we added $3.3 million in net new annual contract value to our on-demand business. This compares to $1.1 million in the second quarter of 2007. Net new annual contract value represents the annual value of contracts signed less any cancellations.

On the license booking side, we had one license over $1 million in the second quarter. The revenue on this transaction will be recognized in Q3. This compares to two transactions in the second quarter of 2007 and one in the prior quarter. Excluding transactions under $100,000, our average license bookings in Q2 was approximate $600,000. This compares to $700,000 in Q2 of 2007. Remember, this number can vary greatly from quarter to quarter depending on the number of $1 million-plus deals we complete.

Let’s look at total revenue. Second quarter revenues were $23.5 million, down 12%. By geography, 85% of second quarter revenue was generated in North America. This compares to 81% in the second quarter of 2007. By vertical, total revenues for the second quarter break down as follows; insurance 23%, banking 17%, high technology, manufacturing and life sciences 37%, telecommunications 17%, and retail and distribution 6%.

License revenues. License revenues were $1.9 million for the quarter, down 53% from the first quarter and 74% from the prior year period. I would like to remind you that there were two additional license transactions totaling $2.7 million that were executed during the quarter, but for which third party elements necessary for revenue recognition had not been satisfied prior to quarter-end. These third party elements have since been satisfied and the full $2.7 million has been recognized in the third quarter of 2008. License gross margin in the quarter was 94%, consistent with prior quarters.

Subscription and support revenues. Subscription and support revenues for the quarter were $10.1 million, up 68%. Subscription and support gross margin for the second quarter was 64%, an increase from the 59% margin in the second quarter of 2007. The increase was primarily due to continued margin improvement in our on-demand business. The growth in our subscription and support revenue combined with the increase in subscription and support margin has put us on a path where we expect to rely less and less upon license revenues to achieve profitability

Let’s look at services and other revenues. Services and other revenues for the quarter were $11.5 million, down 13%. There are a number of factors contributing to the lower services revenue, including much shorter on-demand implementations as compared to on-premise implementations, higher deferrals of service revenue due to project delays, an increase in partner-led implementations, and completion of a number of projects in Q1 which weren't immediately replaced in Q2.

As we look at the decrease in service revenue from Q1, it should also be noted that as well as the impact to these factors just mentioned, we benefited from approximately $1 million in termination fees in Q1. As just noted, we are very focused on margin. Services and other gross margin for the second quarter was 8%, up from 7% in the second quarter of 2007. Included in the margin total, our acquisition related amortization cost of $500,000 and stock-based compensation charges totaling $400,000.

Adjusting for the amortization cost, which did not exist in the prior year, and for the stock-based compensation charges, our services and other gross margin was 16% compared to 8% in the prior year on the same basis. This improvement reflects the cost control measures we have put in place as well as the influence of the acquired Comp Tech team. We will continue to focus on delivering higher margin services.

Overall gross margin. Overall gross margin for Q2 was 39%, down from 43% in the prior year, primarily due to the increased mix of services, subscription and support revenues as compared to license revenues. Adjusting for the amortization cost, which did not exist last year, our overall gross margin was 41%.

Operating expenses. Total operating expenses for the quarter were $13.9 million, which included approximately $1.6 million of stock-based compensation. Stock-based compensation by line item is disclosed as a footnote to the income statement included in our press release.

Sales and marketing expense was $7.1 million, down from $7.3 million in Q1 and down approximately $500,000 from Q2 of 2007. The decrease from Q1 was primarily due to a decrease in general sales and marketing expense, whereas the decrease from Q2 2007 was a combination of lower commissions and marketing spend partially offset by higher stock-based compensation charges. I would like to remind you that the direct commission expense for our on-demand transactions is deferred and recognized along with the on-demand revenue over the non-cancelable term of the contract.

Research and development spend for the quarter was $3.5 million, down approximately $200,000 from Q1 and down approximately $400,000 from Q2 2007. The decrease from Q1 resulted from lower personnel cost, and the decrease from last year is a function of lower headcount.

General and administrative expense was $3.3 million, essentially flat with Q1, but down approximately $200,000 from the same period in 2007. The reduction from Q2 2007 can primarily be attributed to lower personnel cost and a reduction in SOX fees achieved, as we began our third year of compliance.

Overall operating expenses in Q2 continue to reflect the impact of the changes made at the end of 2007 and our commitment to controlling cost. As a result, we experienced reductions both year-on-year as well as from consecutive quarters. As noted to you last quarter, these differences are even more pronounced when you exclude the impact of stock-based comp charges.

On a GAAP basis, operating costs were $13.9 million versus $15 million in Q2 of 2007, a reduction of $1.1 million or 7%. Whereas on a non-GAAP basis, Q2 2008 operating expenses were $12.3 million versus $13.8 million, a reduction of $1.5 million or 11%.

Let’s talk a bit about the business model. From a business model point of view, we continue to see the impact of the growth in on-demand and the relative percentages of revenue. Subscriptions and support recurring revenue streams accounted for 43% of total revenues. At the same time, license dropped to 8% from 14% in Q1.

On the operating side, as a percent of total revenues, sales and marketing was 30% as compared to 26% in Q1; research and development was 15%, up from 13% in Q1; and G&A was 14%, up from 12% in Q1. As we pointed out earlier, we continue to focus on our cost. And the percentage increases reflect the lower revenues, not increased costs. Interest and other income net in Q2 was $192,000. Income taxes. The provision for income taxes was $122,000.

Let’s look at headcount. Our total headcount at June 30, excluding contractors, was 440 employees, up ten from the end of March. The increase was primarily due to the expansion of our on-demand operation and implementation teams required to support the growth in on-demand customers.

Balance sheet and cash flow. We finished the quarter with $48.7 million in cash and investments. This is an increase of $6.5 million since March 31. This increase was primarily driven by changes in accounts receivable and deferred revenues, which I’ll discuss with you now. Our net accounts receivable balance at June 30 was $17 million, down $8 million from March 31. Days sales outstanding for the quarter was 80 days, up two days from Q1. Excluding the impact of the increase in deferred revenue, DSO would have been 71 days. Our collection history has been and we believe will continue to be strong.

Deferred revenue including both short-term and long-term was $22.1 million, up $2.2 million from the prior quarter. The increase occurred in on-demand and deferred consulting services. The increase in deferred consulting services resulted from the large prepayment for implementation services. I would also like to highlight the fact that our deferred revenue balance is up over 60% or $8.5 million from the same quarter last year. This increase is largely a result of our transformation into a recurring revenue business.

During the quarter, we purchased approximately 201,000 shares of our stock for $1.2 million. This brings the total amount repurchased under the Board authorization to approximately 701,000 shares for a total of approximately $3.7 million. We also received approximately $1 million from stock option exercises in the quarter, while capital expenditures were approximately $800,000 in the quarter.

We continue to hold approximately $4.4 million in auction rate securities, secured by student loans. During the quarter, there was no adjustment to the par value of these assets. Our unrealized loss remains at just over $250,000. Given the lack of liquidity at this time, the investments are classified as long-term.

Now let’s turn to Q3. I want to remind you of the Safe Harbor language provided at the beginning of the call. Further, it should be noted that we plan to update any guidance only during our quarterly conference calls. For Q3, we are expecting total revenues between $25.5 million and $27.0 million. At the low end, total revenue would be flat with the third quarter of last year, and at the high end, it would represent a growth of approximately 6 percentage points from the prior year.

Despite the moderate year-over-year growth estimate, we expect our recurring revenues generated from subscription and support services to continue to represent a larger portion of our total revenue in comparison to the prior year. Total revenue is made up of license, subscriptions and support services, and other revenues. While we do not give guidance on annual contract value bookings for our on-demand business as these quarterly bookings can be lumpy, we do however expect our booking to be up significantly compared to the annual contract value booking in Q3 of 2007, which totaled $2.6 million.

With our transformation to a recurring revenue model, it should be remembered that even modest levels of annual contract value bookings increase our cumulative backlog, thus driving future revenues and allowing us to better align our cost structure. Operating expenses are expected to be between $15 million and $16 million and include approximately $2 million of stock-based comp.

Before we open it up for questions, I'd like to remind you we will be presenting at the B. Riley Conference in San Francisco in August. With that said, I'd like to open up the question-and-answer session. Sylvana, can you please prompt for questions?

Question-and-Answer Session

Operator

(Operator instructions) And the first question comes from of the line of Chad Bennett from Northland Securities. You may proceed.

Chad Bennett – Northland Securities

Good enough. Okay. On the service side of the business, just trying to I guess get a sense for where we're at in terms of – I don't know – percentage of service work that's now more on-demand focused versus on-premise focused and where we are in that transition. And is this kind of – is this quarter kind of the standard at least or the baseline looking out at least a couple of quarters in terms of the implementation service line? And have we made adjustments to headcount and whatnot to kind of factor in what might be a lower level of service revenue looking out in the near-term?

Ron Fior

Yes, actually – so, in looking at the on-demand implementation side, it's obviously growing as a percentage of the total services implementations. It is roughly almost 30% of the number in Q2. And we have made those changes that you're talking about in the services side. We have reduced the headcount not only in contractors, but also as people have left, we have not replaced them. We are adding people in the implementation services side of it. So we are trying to make use of some of them there. We definitely need to improve the utilization percentage and that is a huge focus for us in this quarter.

Chad Bennett – Northland Securities

Okay. So, it's at about 30% right now on I guess a couple of weak quarters on the license side. I guess – have we based out yet or is there – can this line trend down more in the next couple of quarters?

Leslie Stretch

Well, I mean I think if we would go back to the top line guidance conscious of where we were last quarter, the guidance (inaudible).

Chad Bennett – Northland Securities

Right.

Leslie Stretch

But for our guidance here, and when you look at the guidance, it doesn't really say that. And I think the other thing is – I think that there is a background trend of moving from perpetual license to more on-demand implementations, as Ron was saying. But if you just look at some of the details of the quarter, we did sign a couple of big – signed quite a few on-demand deals where we signed a couple of big license deals, some of which we will implement.

Chad Bennett – Northland Securities

Right.

Leslie Stretch

So it is a kind of a lumpy business anyway. If you look back over the last couple of years, it has been a very, very lumpy business on the consulting piece. So I think I'm okay with a bit of stability. I see a bit of stability in the next couple of quarters here.

Ron Fior

So – and then just another point on that. So, the point relative to the partners, and remember, I indicated one of the issues was that we did – more of our projects were actually partner-led implementations. If you look back to the prior quarters, that was clearly the case. In this particular quarter in Q2, as Leslie said, many more of the on-premise’s implementations were actually – are going to be done by ourselves, which will stabilize that number I believe.

Leslie Stretch

Two other factors. One is, there was quite a bit of deferrals going on. And we also are focused on quality. We have taken quite a bit of costs out of that business, and the new management team has taken a bit of cost out of it. And so there’s a couple of deals where we just didn't get to sign the contracts because we didn't see the margin profile spinning out to where we want it to be. The first half, I mean, the margin is much healthier than it was a year ago.

Ron Fior

Yes. I mean, as we noted in this particular quarter, I mean, it’s a comparison on a like-for-like basis, excluding the stock-based comp and the amortization. It's 16% gross margin this quarter versus 8% a year ago.

Chad Bennett – Northland Securities

So, that would imply utilization has to be fairly decent, correct? I mean it could have been that far off, right?

Ron Fior

Well, actually, you know, it is – actually utilization was okay, but we also had our average billing rate actually turned out to go up this last quarter.

Chad Bennett – Northland Securities

Okay. Maybe this is another way of asking it. How much visibility do you have going into Q3 for your services in other line?

Ron Fior

Historically, we have had roughly 80% of the number nailed down before we go into the quarter and that's where we are at.

Chad Bennett – Northland Securities

And wouldn't you know – I mean, wouldn't you know going into the June quarter, for example, how much of the business is going to be partner versus you and whatnot? And I mean, how would you get that dramatic of a difference in the business? Is it purely just deferrals?

Ron Fior

In Q1 – sorry, in Q2, it was a combination of two things. One was the higher deferrals; project delays really, that's what happened. And we got a number of deals that the projects were pushed out pretty significantly. We definitely have the impact of these shorter implementation periods. And truth be told, we expected to get – as I just finished saying, we normally have around 80%. We expected to close some other types of business. We tend to usually get upgrade business and other types of strategic consulting to go on, and we did not get the typical add-on business during the quarter.

Chad Bennett – Northland Securities

Okay. And then just shifting to the on-demand piece of the business, can you talk about – maybe it's for Leslie. Can you talk about the strength in that business, I guess, looking into the last month of July kind of post-quarter? What are you seeing on that side of the business? Is there anything on the macro side that's scaring you either by region or by vertical? Or – it seems like bookings guidance is still pretty strong year-over-year. Can you give us a sense of what's going on in the on-demand pipeline?

Leslie Stretch

Yes. I think it’s pretty healthy. I think the macroeconomics are what they are and they're just the same for everybody. And so we just go out and battle that anyway. What can it be else? So I think the difference this year over previous years is we are more diversified both geographically and vertically. So, with the Latin America thing coming on stream, I'm really pleased with what CIS is doing, couple of big deals. I mean, they have really sizable deals under their belt now. And that's on-premise. If you look out to Europe, but it's mostly on-premise although we signed our first on-demand deal in Q1, so – with IMS actually. And so there's kind of those differences going on. And North America is where most of the on-demand action is and I see they are doing well. I'm pretty positive about that. Summer quarter is typically – the seasonality for us is we have a good Q4. Some of that falls over into good Q1. Q2 and Q3, we never have anything special. Having said that, I feel pretty good about it and that's reflected in the guidance.

Chad Bennett – Northland Securities

Okay. And just last question on OpEx, based on your guidance, OpEx is going to tick up a little bit sequentially. Can you talk about kind of what's that – why that is, I guess, and what areas will tick up?

Leslie Stretch

It’s really simple, Chad. It was called [ph] no bonuses were paid in Q2, period. And for the whole company, that's a big number. And that basically, if you had added all those back in, you would have probably been roughly flat with last quarter.

Chad Bennett – Northland Securities

Okay.

Ron Fior

The operating expenses.

Chad Bennett – Northland Securities

And we're assuming people are getting bonuses this quarter?

Ron Fior

Absolutely.

Chad Bennett – Northland Securities

I'm just kidding.

Leslie Stretch

Absolutely, we are presuming – it won't be too big though.

Chad Bennett – Northland Securities

Good. All right. And then just one last quick one. When you have the ability to be back in the market buying back stock, are you guys going to continue to use that as a deployment for capital?

Leslie Stretch

Yes, we continue to – we would expect to be back in the market once our open period is back in place.

Chad Bennett – Northland Securities

Great, thanks.

Operator

And the next question comes from the line of Mark Murphy from Piper Jaffray. You may proceed.

Mark Murphy – Piper Jaffray

Yes, good afternoon. Thanks a lot for taking my questions. Ron, I was just wondering, could you repeat what was the time frame for when you will begin the transition to term licenses?

Ron Fior

We basically suggested that we'd be looking to do that in the first half of 2009.

Mark Murphy – Piper Jaffray

Okay. First half of 2009, great. And then what do you think the level of license revenue decline should be here then as we get into these time frames beyond 2008? How do we – how would you be modeling the license revenue line as you begin this transition?

Leslie Stretch

I'd just say – I’d say, first of all, the plan was (inaudible) $3.5 million, $4.5 million, $5.0 million range a quarter, and we’ve mapped that out this year in order to manage the bottom line. With the two bookings where we want to take the revenue last quarter, that came off the rails for that reason. Otherwise we would have been pretty much in synch with our plans. And I see in this quarter and the next quarter, we are looking at a level of license that helps us deliver what we said we would do in the bottom line and helps us recover somewhat from where we got to last quarter, not least from a credibility point of view. So I actually see that as being – in Q3 and Q4 as being pretty solid, and then you got to go back and look at the fact that we got $2.7 million done at the start of the quarter already anyway now with the two deals that tipped over. And then we get into next year, the same approach is going to be there, which is how does the overall business look, how does the bottom like look, are we getting to that target point where we have a healthy bottom line with more subscriptions. And that’s where we pull the trigger, not before. And with the on-premise business, we have that flexibility.

Mark Murphy – Piper Jaffray

And so Leslie, does that translate into growth or decline or kind of a net neutral situation for 2009 on the license revenue line?

Leslie Stretch

On the license revenue line?

Mark Murphy – Piper Jaffray

Yes.

Leslie Stretch

Given that the term piece would actually move down into recurring revenue, it would be a net decrease in the license line.

Mark Murphy – Piper Jaffray

Okay. So that's where you are going to recognize the terms. So then I guess, ultimately, can you help us to understand maybe what value of term licenses is going to be coming kind of out of one line and going into the subscription line?

Leslie Stretch

I don't know if we are ready to do that. We got – we are still working on the algorithms there. We’ve done a bunch of work with some other companies that need to transition successfully. And as we say, it’s first half 2009, and it’s dependent on how the bottom line looks. We're not just going to do it irrespective of other factors. So I think we are not ready to do that, but there are some pretty well trodden algorithms out there with a perpetual license and that makes sense from a customer perspective in terms of the outlay. And that's what we're working with at the moment.

Mark Murphy – Piper Jaffray

Okay. I also was wondering, could you update us on the number of on-premise payees that you currently have?

Leslie Stretch

It is in excess of 1.9 million payees.

Mark Murphy – Piper Jaffray

Okay. So it’s around 1.9 million on the on-premise and then the on-demand number of payees were at 66,000 now?

Leslie Stretch

Correct.

Mark Murphy – Piper Jaffray

Could you help us to – can you help us to gauge maybe where you would envision that mix moving over the next couple of years as you – particularly, again, as you kind of embark on this transition to go to term licenses?

Leslie Stretch

Yes – I mean, there's a couple of good base points in there. Two key data points are when a customer converts or an on-demand customer, as we said in the script, we are getting implementations done in roughly half the time. We control many more of the variables. It’s less revenue, but it’s kind of more margin controllable is better for the customer. The other data point is that when we convert an existing customer, we are getting close to 5x the revenue, the old revenue payments. There is much more value we are delivering and that is great value for the customer, even though it is a multiple of the maintenance. However, we have only converted something like 10, 11 or so customers. Most of our on-demand customers are new business in markets that we weren't in. This year, for the first time, we got a small group of people focused – dedicated to the conversions. We haven't done that before. We are only six months into that program and we are seeing how it plays out. Clearly, if we can get the 1.9 million payees, as many of them moved over as possible, the equation is a really interesting one. But we are taking it reasonably steady at the same time as growing the market.

Mark Murphy – Piper Jaffray

Okay. And just one final question. How would you characterize the aggregate pipeline? I guess in particular, as you look at the coverage ratio, kind of the pipeline divided by the guidance that you are giving here for Q3, how would you characterize that entering Q3 versus maybe where that stood a couple of quarters ago?

Leslie Stretch

I feel very good about the pipeline, the aggregate pipeline. And let me just say, unscripted. We felt good about our guidance obviously for Q2 and we missed it by then of the services issues and the trip-over of the license bookings. So, we have come here to the table giving guidance today with that in mind. We got to do better. So, that tells you that we think the pipeline is enough to deliver against our guidance. But the difference now versus a year ago is we have totally different visibility. We see almost 100% of the subscriptions revenue already and we see a nice growth in the subscriptions revenue. We see that now. We saw that in day one of the quarter. We talked a little bit about what we see in terms of coverage for the consulting business, we just talked about that, sort of an 80 percentage figure. The other balance is the license, and we got 2.7 of that done. So I think when I look at the pipeline against that, I feel pretty good.

Mark Murphy – Piper Jaffray

Okay, great. Thank you very much.

Operator

And the next question comes from the line of Kevin Liu from B. Riley & Company. You may proceed.

Kevin Liu – B. Riley and Co.

Hi, good afternoon. Looking at Q2 in terms of your professional licenses, if that 2.7 million had been recognized in the quarter, your licenses would have been greater in terms of the bookings on the ACV? And so I'm just curious as we look in the back half of the year. What's kind of the mix between perpetual versus on-demand? And also on the perpetual side, are you guys going to start trying to negotiate some term licenses within this year even though the transition should take place next year?

Leslie Stretch

Yes. The mix doesn't change a great deal, but there are some lumpy deals out there. There are some large enterprise deals on both sides that we should go after. And so that's why we don't give individual license or ACV guidance, both figures would be lumpy. The different of ACV of course is that it accumulates. In terms of term license, we experimented with one term license in Q2 that we executed. So – and we found no resistance, pretty straight forward. We did it on the basis of what we have done with the third party company that have already done a transition to term license. And so we are beginning to look at that. We’ve got a few promotions on term license now, but our real focus is to deliver the bottom line in 2008 that we said we'd deliver. And for that, we need the level of – the sort of level of perpetual licenses, as we just talked about.

Kevin Liu – B. Riley and Co.

And then I think in your comments you guys mentioned that during the second quarter, it looked like the deals coming out of the partner channel were a little bit lower. So, just wondering what you guys are seeing there. Has that pipeline picked back up, or are you closing more deals directly? And then also if you could comment on whether any deals were closed with IMS and what the pipeline for that looks like?

Leslie Stretch

We did – in the quarter, we actually did – we had a trifecta of SAP – we did an SAT deal, we did an IMS deal, and we did a CIS deal in Latin America, which for us is a small deal, but it's actually quite high and we hope they'll do well. I really feel good about the Latin American partnership. They specialize in on-premise, pretty large on-premise. Vivo is one of the largest mobile telcos in Latin America. CIS specialized in that. The previous company was Seguros Banamex, big companies. I expect more from them. IMS is beginning to get some traction. We are just a quarter and a bit into that. We did their second deal. And then we go from there. We have also got a partnership in Eastern Europe that I hope will bear fruit in the second half.

Kevin Liu – B. Riley and Co.

All right. Thank you.

Operator

And the next question comes from the line of Ariel Sokol from Wedbush. You may proceed.

Ariel Sokol – Wedbush Morgan

Hi guys, good afternoon.

Leslie Stretch

Hi, Ariel.

Ariel Sokol – Wedbush Morgan

So I just got a more macro question than some of the questions being asked here, and maybe we could focus a little bit on the pervasive performance management. Could you provide some color on the competitive landscape? Just trying to get my hands around who you will potentially be competing with. With the likes of the success factors of the world or are you competing against internal systems within enterprises?

Leslie Stretch

I think we believe that we targeted largely a Greenfield area that’s may be some old internal systems and manual processes. And I think we believe that we are coming at the business problem from a – more from a numbers perspective than some of the HR vendors. So more from a – you know, the quantitative capturing measurement of quantitative data about any of these performance is not well developed. And we met with a number of clients, we met with a major European bank, we met with their global head of rewards. They have kind of laid out the framework for that. And a number of other clients here in our customer advisory board, they kind of laid out that they felt there was a gap. And they all use those other solutions. They use the HR vendor solutions, which combat the problem from a different angle.

Ariel Sokol – Wedbush Morgan

Okay. I guess the next question will be the value proposition that the software during a period of economic weakness, what's been the response you had through the sales cycles? Is it the value proposition more important now that people are focusing on cost savings?

Leslie Stretch

We honestly think it is. I think the – we’ve got category leaders in retail and telco and banking. To get 35 big telcos now under our belt, and there are still another couple of hundred giant ones out there I believe and we haven't even gotten into India yet. There are some great opportunities for us. We believe that commissions and incentives and performance analytics are more vital in the downturn than any other time, so to some of those large clients. I mean, if you took it away from one of our largest retailers, it’s got nearly 150,000 payees under management. If you took that away from them at this stage, it’s the 2% that they pay commissions in the stores that drives everyone's behavior. If you took it away from them, their business – they believe their business have a real problem. So it is mandatory for that class of company. And then that's the discussion that we're having, I think the aggregate – it feels to me like the aggregate demand is definitely there even in – the macroeconomic thing has been with us for more than a year now and we just have to live with it.

Ariel Sokol – Wedbush Morgan

Okay. Well then, moving on to questions in a similar vein and other people have asked in this call. Do you have a sense kind of very high level when Callidus could start generating subscription revenue at around, let’s say, 60% of total revenue? Is it a 2009 event, is it more like a 2010 event?

Leslie Stretch

Well, I think – first of all, we want to generate subscriptions as a proportion of a decent revenue number. We don't want to get there by then by bringing the top line down anymore. That's for sure. So, we feel pretty good about it. I think the unknown is the impact of the term license piece, which – we don't – we are not going to transition to until we got the bottom line stable. Then that adds the subscription line as an addition to the on-demand piece. And it’s something that customers still want and we are going to provide it to them, but we are going to take it as a subscription. So, our target is to get all of our products related – our SaaS related business into the subscription bucket. And then a real good model to think about would be to have a 20-points-plus of margin in the consulting business. The consulting business would be about 30 percentage points of the overall piece and then the rest would be recurring revenues. That’s where we really need to – that's our kind of mental goal where we want to get to.

Ron Fior

I think on a total – and we have done some modeling out obviously into 2009. And by the end of 2009, we would definitely be – we would be getting closer to that number, the 60%, I think in my mind. It’s going to be a function of how much we continue to add in on – is this including – I'm including maintenance in that number of recurring revenues. But if you include that in there, I would see by the end of 2009 we should be very close to that at least as a run rate and on an ongoing basis.

Ariel Sokol – Wedbush Morgan

Okay. And then the last question. I think it speaks to this one is – assuming that bookings are flat for the remainder of the year, what kind of growth rate do you think that you can generate for subscription revenue in 2009, assuming on-demand and maintenance, not assuming any benefit from licenses and term licenses?

Ron Fior

So, try that again –

Ariel Sokol – Wedbush Morgan

So maybe to restate that; maybe I guess, part A, part B. Part A would be, what kind of growth rate could you get for on-demand subscription revenue. And then the broader question is, assuming that you don't have a conversion of licenses in the term licenses, what kind of growth rate do you think you can get in the subscription of revenue line item, assuming flat bookings.

Leslie Stretch

Hold on a second.

Ron Fior

Assuming flat bookings, I mean, somewhere at around $4.5 million or so or $5.0 million a quarter. We would – the mathematics works out that it's probably close to 100% year-on-year growth in revenue. Assuming that we are able to sign these deals on an effective dating that we currently are doing the majority of our deals on at basis, yes, it would be very close to 100%. This year it’s – it will be over 300%, but next year it would be at least over 100% next year on the revenue line for subscription – on-demand subscription revenue.

Ariel Sokol – Wedbush Morgan

Okay, that's very helpful. Thank you.

Operator

And the next question comes from the line of Ted Ketterer from TK Associates. You may proceed.

Ted Ketterer – TK Associates

Hi guys.

Leslie Stretch

Hi.

Ted Ketterer – TK Associates

Hi, Ron, or Leslie. I just had one question. Leslie, you have been talking about the relationship with salesforce for some time now. Can you give us some color or elaborate on what you see the potential is and just in terms of numbers and where you think you can go with salesforce?

Leslie Stretch

Yes. I think it’s – we saw [ph] three quarters and maybe two and a bit quarters actually into the thing to be fair. And we did 20 transactions last quarter. That was a high transaction count for us historically. A couple of years ago, we were playing around the two or three. I attribute quite a lot. We had 11 or so on-demand engagements that we won head-to-head with typical players. And I'd say a lot of those came – those interactions with salesforce, a lot of those leads came from salesforce. We want to benefit from their platform. We can hold, we can go and hold a user event for our users and bring in 20 or 30 prospects, or we can go to their – we can ride along on their platform, which is the model, and see 4,000, 5,000 prospects in one hit. We attended Dreamforce in Europe. We are beginning to see flow from that. So I think the potential is huge if we work it and we are continuing to work hard and invest in it. To date, we have spent a little bit, not a lot. We’ve just reviewed our plans there. And with the force.com app that we’ve released, we intend to back that out with some problem markets doing effort and focus. So it’s another strand to the business. And we are not going to bet everything on it. It is another strand. And they are light applications, self-subscribed. We build the force.com application. In fact, our onshore product leader was here and we built it offshore in 3.5 months, which is not a typical product cycle for the company. A typical product cycle is years. So we got it there quickly. We are bringing it out to market now in the next few days or so. There are four or five candidate applications; force.com applications that we think merit us going ahead. We have already done the feasibility, going ahead and building. It is a great platform to build that class of application on and this is just a huge marketplace. So, still very early days is what I'm saying, but I attribute some of our 20-odd transactions in the quarter directly to that relationship.

Ted Ketterer – TK Associates

And just refresh my memory, your 63,000 on-demand payees right now, and what were you at the end of the year, end of '07?

Leslie Stretch

In ’07, give us a minute, we will pull it up.

Ron Fior

We are going to get that for you. Is there another question?

Ted Ketterer – TK Associates

Yes, just how many payees a quarter are you adding on average?

Ron Fior

We're just pulling up – sorry.

Ron Fior

We are adding – where is the payee, there we go. So at the end of Q4, we were at about 34,000 – 35,000 payees. So, over two quarters we have added now – we did add I think roughly 10,000 front Comp Tech in the first quarter and – but other than that, you are then looking at roughly 10,000 – 10,000 to 12,000 a quarter.

Ted Ketterer – TK Associates

Okay. And then my last question, Ron, going back to SAP?

Ron Fior

Yes.

Ted Ketterer – TK Associates

Congratulations on signing that deal, but one of the elusive many, many millions of dollars of (inaudible).

Ron Fior

I know.

Ted Ketterer – TK Associates

Has there been – is the prospect of having an OEM with them still alive or is that a dead issue?

Leslie Stretch

I think they brought us a phenomenal branded customer, big deal. It’s one of the deals that tipped over, big deal for us. If they can bring us one of those every once in a while, they are a great partner to work with. And we should – we keep that open. We still have an agreement with them. So, by no means a dead issue. North America, we expect to do more.

Ron Fior

But not necessarily an OEM.

Ted Ketterer – TK Associates

Okay.

Ron Fior

Not necessarily an OEM.

Leslie Stretch

Not necessarily OEM, yes.

Ted Ketterer – TK Associates

And then last, one of the issues on the services if my memory is correct from the earlier call was that there was about $1 million that they had not hit the milestones?

Ron Fior

Yes. And that just pushed everything. What happened was there was delays, so it pushed everything out and that will be coming through in this quarter. But it pushed everything else out too. So the whole project has actually been pushed out a fair bit. It has actually grown in size. The actual particular product – project has grown in size by over $1 million just in the last week, but it has actually just moved out. I mean, one of the things that is interesting is that our – actually deferred revenue and backlog on these projects that we are working on right now in services is actually at a relatively high level compared to – definitely higher than last year. And so there are some good strength there, but it is being spread out unfortunately over a longer period of time right now in the regular implementation services side.

Ted Ketterer – TK Associates

But it’s signed back on.

Ron Fior

It’s signed back on.

Ted Ketterer – TK Associates

All right. That's just going to take longer than we hope. Okay.

Ron Fior

Yes. Thank you.

Operator

(Operator instructions) And your next question comes from the line of Gregg Speicher from Moss Creek. You may proceed.

Gregg Speicher – Moss Creek Capital

Hey guys. Since we are talking about services, I just want to make sure I heard you correctly earlier. Did you say you thought service revenues would stabilize in Q3? Is that part of that guidance?

Ron Fior

Yes, basically.

Gregg Speicher – Moss Creek Capital

Okay, okay. So we shouldn't see a continued downward trend if the other factors should start reversing a little bit?

Ron Fior

We are not planning for a downward, let’s put it that way.

Gregg Speicher – Moss Creek Capital

Okay, okay, that's fine.

Leslie Stretch

And the key governor is, we did have a deal last quarter where we turned it away, delayed, because the margin profile didn't work out.

Gregg Speicher – Moss Creek Capital

Okay.

Ron Fior

So, the key governor for us is what margin are we getting, what’s the quality of the revenue we are getting from that business. But we should be okay based on the guidance that we gave you.

Gregg Speicher – Moss Creek Capital

Do you know if some of those deals went elsewhere or maybe they'll go, hey, maybe we should just go with Callidus, or do you know what happened to those deals?

Leslie Stretch

(inaudible) particular one came back. Well, it is coming back.

Ron Fior

Back in discussion.

Gregg Speicher – Moss Creek Capital

Okay, okay. That's good. So, these license deals that sort of got recognized early this quarter, were you – have you been paid on those in Q3 or Q2 or not yet?

Leslie Stretch

No, we haven't received the money on them yet.

Gregg Speicher – Moss Creek Capital

Okay, okay. I just want to make sure I didn't mishear that.

Ron Fior

And we would hope that we get them paid for by the end of this season.

Gregg Speicher – Moss Creek Capital

Okay.

Leslie Stretch

These are pretty large companies. Third largest software company in the world and the largest telco in Brazil. So –

Ron Fior

They better pay us.

Gregg Speicher – Moss Creek Capital

I mean, this whole market has been sort of a rising boat for the last year or two now, I guess, and I’ve got to think that some people are trying to move in. Would you say there is more competition coming from some of the big guys or are some of the smaller private players starting to get it together as well?

Ron Fior

We’ve done a pretty good analysis, in fact, a very good analysis of the competitive landscape for the past 12 months, right up to date. And there are some small private players who are able to sign some of the smaller high tech companies in California. But outside of that, they will certainly translate very well, particularly to Europe and other places. And we competed 11 times with a couple of them directly and won out. So – yes, it is an attractive market though. And the big players, they are still not that focused, they got such big portfolios and it is so specialized. But it is a very attractive market. It’s definitely – we’ve got 20 transactions, we’ve got the on-demand piece of the business, the perpetual license piece of the business, the on-premise license. We’ve also now got this force.com thing going along. So, it is a very attractive market.

Gregg Speicher – Moss Creek Capital

Okay. And what kind of visibility do you have on the capacity needed, for example, for like the next 10 million to 15 million of on-demand bookings versus the last 10 million to 15 million? Will that be flat or does it just depend on the client? What kind of visibility do you have into that?

Leslie Stretch

I think pretty good. In terms of planning the capacity and the resources –

Gregg Speicher – Moss Creek Capital

Right. Obviously, I'm asking you about sort of the margins down the road, etc, cash flow needed to get there.

Leslie Stretch

Yes – no, I think we have proven that out. We have had two years practice now and we got to 23 points in Q1 or whatever it was, 22, 23, and then 45 this quarter. I think we expect that to – the margins to be healthy there.

Gregg Speicher – Moss Creek Capital

Okay, great. Thanks a lot.

Ron Fior

Thanks, Gregg. Operator, I think that's it.

Operator

No problem. And I will turn the call over to Mr. Leslie Stretch, President and CEO of Callidus Software.

Leslie Stretch

I'd like to thank you all for joining us today and we look forward to speaking with you again next quarter.

Ron Fior

Thank you.

Operator

Thank you, ladies and gentlemen, this concludes the presentation. You may now disconnect.

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Source: Callidus Software Inc. Q2 2008 Earnings Call Transcript
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