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NetSuite (NYSE:N)

Q3 2012 Earnings Call

October 25, 2012 5:00 pm ET

Executives

Ronald Gill - Chief Financial Officer and Principal Accounting Officer

Zachary Nelson - Chief Executive Officer, President and Director

Analysts

Gregory Dunham - Goldman Sachs Group Inc., Research Division

Jason Maynard - Wells Fargo Securities, LLC, Research Division

Philip Winslow - Crédit Suisse AG, Research Division

Laura Lederman - William Blair & Company L.L.C., Research Division

Stan Zlotsky - Deutsche Bank AG, Research Division

Brendan Barnicle - Pacific Crest Securities, Inc., Research Division

Jennifer A. Swanson - Morgan Stanley, Research Division

Operator

Thank you, everyone, so much for holding, and welcome to the NetSuite Reports Third Quarter 2012 Financial Results Conference Call. Just a quick reminder, today's call is being recorded. [Operator Instructions] And now, at this time, I'll turn things over to Mr. Ron Gill, Chief Financial Officer. Please go ahead, sir.

Ronald Gill

Thank you, operator. Good afternoon, everyone, and welcome to NetSuite's third quarter 2012 financial results conference call. A more complete disclosure of our results can be found in our press release issued about an hour ago, as well as in our related Form 8-K furnished to the SEC earlier today. To access the press release and the financial details, please see the Investor Relations section of our website. As a reminder, today's call is being recorded and a replay will be available following the conclusion of the call.

On the call with me today is Zach Nelson, our Chief Executive Officer. Zach and I will begin with prepared remarks and then we will open up the line for questions.

During the call, we'll be referring to both GAAP and non-GAAP financial measures. The reconciliation of our GAAP to non-GAAP financial information is provided in our press release, which is available on our website. All of the non-revenue financial measures we will discuss today are non-GAAP, unless we state the measure is a GAAP measure.

The primary purpose of today's call is to discuss our third quarter 2012 results. However, some of the information discussed during this call, including any financial outlook we provide, may constitute forward-looking statements within the meaning of U.S. federal securities laws. These statements are subject to risks, uncertainties and assumptions and are based on financial information available as of today. We disclaim any obligation to update any forward-looking statements or outlook.

Risks and uncertainties that would cause our results to differ materially from those expressed or implied by any such forward-looking statements include those summarized in the press release that we issued today. These risks and additional risks are also described in detail in reports that we file from time-to-time with the SEC, including our most recent 10-K and 10-Q filings, which I encourage you to read.

With that, I'll now turn the call over to Zach.

Zachary Nelson

Thank you, Ron, and thank you all for joining us today. I'm really excited to announce our results for the third quarter of 2012. Third quarters are typically somewhat difficult, with summer vacations, much of the quarter's activity is delayed into the third month of the quarter. In NetSuite's case, last year's Q3 was remarkably strong, making the comparison even more difficult. As I described that quarter on this call a year ago, I characterized our results as setting a record for records. Hence, given the traditional Q3 challenges and the tough comparison period, we planned Q3 2012 to be relatively flat. I am very happy to report that our planning assumptions were wrong, and today, we are reporting a very strong quarter that exceeded our stated outlook on every measure. On the top line, non-GAAP, bottom line and cash flow. Also, total deferred revenue grew at 40% year-over-year, the fastest growth rate ever since we became a public company.

I am also pleased to announce that, based on the results of this quarter, our new business growth and the record customer revenue retention we have experienced in 2012, we will be raising our outlook for the remainder of the year for revenue and non-GAAP EPS. And finally, we are excited today to give you a first glimpse of our 2013 business outlook, which is well above the current top line consensus analyst estimates. Let me start with some detail around the financial and strategic highlights of Q3 2012.

On the top line, our revenue grew by 31% year-over-year, to a record $79.8 million for the quarter. We achieved record levels of non-GAAP operating income in Q3 as operating income grew 49% year-over-year to $6.4 million. At $5.7 million, our non-GAAP net income also grew 49% over the year-ago quarter. Our non-GAAP EPS of $0.08 in Q3 2012 was a new record and ahead of analyst estimates of $0.05 per share.

In addition, we saw another quarter of very healthy year-over-year growth in operating cash flow. Q3 operating cash flow was $15.2 million, up 61% from $9.4 million in Q3 of 2011. We now have more than $175 million in cash on hand.

And finally, as I indicated earlier, our year-over-year total deferred revenue grew an impressive 40%. In addition, short-term deferred revenue accelerated from approximately 30% year-over-year growth in the year-ago quarter to 40% year-over-year growth in the current quarter. Calculated billings, defined as quarterly revenue, plus the change in deferred revenue, grew 34% year-over-year.

A deeper look at some key metrics reveals what is driving this momentum, and a big part of our success can be attributed to our move upmarket, both in terms of selling to larger midsized companies, as well as to continued success of our two-tier ERP strategy in large enterprises. In total, in Q3 2012, we added approximately 300 new customers. Average selling price across all of our offerings continued to grow and was up more than 11% over the prior year. This growth in average selling price across our full product line reflects the increasing value customers place on our powerful offering, as well as our continued success in moving upmarket and our suite strategy.

Our NetSuite OneWorld offering for multinational multi-company enterprises had a very strong quarter as well. OneWorld sales as a percentage of new business was at an all-time high and was above 40% for the fifth consecutive quarter. Average selling price was again above $100,000 per year.

In the quarter, we also continued momentum in our move upmarket with the signing of more deals over $200,000 than in any other quarter to date. Not only did we sign the highest number of deals over $200,000 in Q3, but also the number of deals over $200,000 grew more than 60% versus the year-ago quarter.

Historically, we have talked about NetSuite OneWorld and two-Tier ERP deployments primarily as an application of NetSuite to support the horizontal financial management needs of large enterprises. And certainly, that has been an important driver of the business, as I believe we have the best multilingual, multicurrency, multi-tax, multi-company offering of any product available, including the largest ERP solutions from companies like SAP.

A new important driver of two-tier ERP is beginning to emerge and that is the use of NetSuite in specific functional deployments. Our announcement today at MRM Worldwide is one such example. MRM is part of the McCann Worldgroup, an interpublic company, and is a leading digital agency with 31 offices in 22 countries around the world that count the world's leading brands among its clients, including Bristol-Myers Squibb, General Mills, General Motors, Johnson & Johnson, Kraft and the U.S. Army. MRM is using NetSuite to functionally automate its global services delivery processes. MRM is rolling out NetSuite's industry-leading professional services automation solution as a global solution to thousands of its professionals around the world to manage core processes such as time and billing, project management and resource management.

While MRM runs its financials on a traditional on-premise ERP solution, the mission-critical business activity of delivering their services to companies around the world is powered by NetSuite.

NetSuite SuiteCommerce is also beginning to take off in these two-tier functional deployments. As you recall, we announced our next generation of SuiteCommerce at our SuiteWorld User Conference in May as part of our Commerce as a Service initiative. Our new version of SuiteCommerce was designed to complement our existing offering with a new approach and new technology that could support the world's largest and most brand-conscious companies. And during the quarter, we saw this strategy pay off with 2 large multibillion dollar retailers committing to NetSuite SuiteCommerce as a future platform for moving their operations online.

NetSuite as an Ecommerce platform has been remarkably successful over the last decade and today, our customers who use NetSuite as their commerce system are running more than 2,800 websites worldwide. And while we move upmarket with our new SuiteCommerce Enterprise offering, our strength in supporting the needs of small and midsized e-tailers continues to be strong. In the quarter, we had a number of new wins in our traditional midsized commerce markets as well.

LittleMissMatched, a new win announced this quarter, is a great example of this unique, but frequent deployment of our new technology. For those of you who have daughters, you are probably very familiar with LittleMissMatched, a fast-growing innovative brand targeting the tween market. After struggling with a hairball of on-premise, disintegrated, Stone Age software, they moved their entire offline, online and retail operations to NetSuite's SuiteCommerce. The NetSuite solution they deployed includes Ecommerce; omni-channel sales across B2B interactions, spanning small retailers to large wholesale partners such as QVC; B2C commerce; and retail support. In addition, full functional ERP, including in the deployment, including financials, inventory management, order management and full CRM management, was also included covering marketing automations, promotions and merchandising.

I would encourage you to go to littlemissmatched.com to see what a next-generation ERP/CRM system looks like. Everything you see on those pages, from the images and web design, to the pricing, to the transaction processing is coming out of their instance of NetSuite. It shows you just how different NetSuite is as a platform. No other ERP system can deliver this unique approach to running a business.

So all in all, it was another great quarter that followed a string of great quarters. Our organization is set up for a great Q4 and we are looking forward to an exciting 2013.

Following our CFO, Ron Gill's comments detailing our Q3 performance, I will provide you an early peek into our view of and thinking around our 2013 plan. So with that, let me turn it over to our CFO, Ron Gill.

Ronald Gill

Thank you, Zach. Well, as Zach highlighted, we had a very strong quarter and continued building on the momentum we generated in the first half of this year. Let me take you through some of the Q3 numbers in detail. As a reminder, all the nonrevenue financial figures I will discuss here are non-GAAP unless I state the measure's a GAAP number. Revenue numbers are, of course, GAAP numbers and, as always, you can find a reconciliation of GAAP to non-GAAP results in today's press release.

Our revenue for the third quarter totaled $79.8 million, up 6.8% sequentially and up 30.9% over Q3 of 2011. Recurring revenues from subscription and support in Q3 grew 7% sequentially and 27.3% over the year-ago quarter to $65.3 million and accounted for 81.9% of our total revenue. Our nonrecurring revenue, which comes predominantly from Professional Services, was $14.5 million for the quarter and grew 50.3% over that for the same period last year, driven by both a significant increase in the number of hours worked and a continuing rise in our average realized hourly rate.

So the business has continued to accelerate very well this year. On a year-over-year basis, Q3 2012 had the highest growth rate of recurring revenue since Q1 of 2009, the highest growth rate of Professional Services revenue since Q2 of 2008 and the highest growth rate of total revenue that we've seen in 4 years. Approximately 26% of Q3 revenue was generated outside the United States, in line with the prior quarter and with Q3 of last year.

Foreign exchange movement did not have a significant impact on results for the quarter, but the stronger U.S. dollar versus the year-ago quarter did have the impact of slightly reducing both revenue and expenses. Overall, the impact of foreign exchange fluctuation reduced U.S. dollar revenues by about $350,000, while reducing costs by about $460,000, for a net positive impact on non-GAAP net income of approximately $110,000 in the quarter.

As you can calculate from the financials published in the press release, calculated billings, defined as revenue plus the change in deferred revenue, were $85.4 million for the quarter, representing an increase of 33.8% over the third quarter of last year. As I have consistently pointed out on these calls, there's a wide array of factors that influence calculated billings and quarter-to-quarter fluctuations in the calculated billings metric may not be a reliable indicator of changes in future revenues.

Our average total selling price on new deals increased 11% over that for Q3 of last year, while the average value of the recurring portion of new deals grew 16% and reached a new record. Our OneWorld product, which is typically purchased by larger customers with more complex operations, had a very strong showing with OneWorld penetration at an all-time high, accounting for more than 40% of new business in the quarter.

Moving down the P&L to gross margins. The gross margin on recurring revenue was 85.1%, up from 84.8% in Q2 of this year. The gross margin on nonrecurring revenue grew to 13.4% from 10.7% in the year-ago quarter. Total gross margin was 72% versus 73% in the year-ago quarter. Margins on both recurring revenue and Professional Services improved over the prior year so that slight degradation in the total gross margin is simply due to the slightly higher ratio of Services revenue in the mix in 2012 versus the prior year.

Turning to our non-GAAP operating expenses. Product development expense was $9.9 million for the quarter, up 7.5% over Q3 of 2011 and about 12.4% of Q3 2012 revenue. We continued to make significant and efficient investment in our product development team. While spending in that area was up 26% year-over-year, total headcount in the group ended Q3 up 49% over the end of Q3 2011.

Sales and marketing expenses were $34.4 million or 43.2% of revenue in Q3, down from 44.1% of revenue in the year-ago quarter. Total headcount in the sales organization was up about 30% year-over-year in Q3. We're continuing to invest in additional marketing activity and in sales capacity in the second half of 2012, and I expect we'll see the sales and marketing expenses increase slightly in Q4 as a percentage of revenue as we make these investments.

G&A expenses were $6.8 million or 8.5% of revenue in the third quarter. That's down from 9.1% of revenue in Q3 of 2011, so G&A continues to scale well. Non-GAAP operating income in the second quarter was a record $6.4 million, an increase of 49% over that for Q3 in 2011. This equates to a non-GAAP operating margin of 8.1% compared with a 7.1% margin in the third quarter of last year.

During the quarter, we reported a net income tax expense of approximately $600,000, principally related to our International operations. For income tax purposes in the U.S., we continue to expect our net operating losses to offset any domestic earnings for the foreseeable future. Non-GAAP net income for the third quarter was another record at $5.7 million, an increase of 49% over the year-ago quarter. Non-GAAP earnings per share for Q3 was $0.08, up from $0.05 in the year-ago quarter.

Moving on to the balance sheet. We closed the quarter with $178.5 million in cash and cash equivalents and minimal debt. That represents an increase in our cash balance of $51.7 million or 41% over the balance we had just a year-ago at the end of Q3 2011. Cash flow from operations in Q3 was $15.2 million, up 61% year-over-year.

Moving down the balance sheet from cash to deferred revenue. Our total deferred revenue balance increased to $135.5 million, an increase of 4.3% over the prior quarter, and up 40% over the prior year. Total headcount on September 30, 2012, was 1,630, up 143 heads from Q2 of 2012 and an increase of 31% from Q3 of 2011. We added headcount across the organization with the majority of the additions coming in product development, direct sales and Professional Services.

Now, I would like to move on to the forward-looking financial outlook, which is covered by the cautionary language I outlined at the start of the call, and based on assumptions which are subject to change over time. For the fourth quarter, we're expecting revenue of $82.5 million to $83 million. If you add the quarters, you'll see this means we are increasing our full year 2012 outlook once again from the prior range of $300 million to $305 million, to a new range of $306.3 million to $306.8 million. We anticipate non-GAAP EPS in this quarter of $0.03 to $0.04, implying a full year total of $0.23 to $0.24, again, ahead of our previously stated range.

As you can see from the EPS range, we plan to accelerate some investments in the fourth quarter, and that will drive some increase in cash spend. We expect operating cash flow for the fourth quarter to be in the range of $12 million to $12.5 million, implying a value for the full year in the range of $52.8 million to $53.3 million, which is within our previously stated outlook of $50 million to $55 million. So one more quarter of accelerating revenue growth and, overall, very solid execution across the business.

That concludes my prepared remarks, and since I know he's eager to talk about what's to come next year, I'll turn the call back over to Zach.

Zachary Nelson

Thanks, Ron. 2012 has been a great year for NetSuite. Our suite approach is transforming how midsized companies operate and gives them a business platform more powerful than those used by the world's largest companies. In addition, this year's investments in our product, sales and services approach to bring the benefits of NetSuite to the world's largest companies has been one of the most successful initiatives in the history of our company. And the SuiteCommerce product that we rolled out this year is changing the playing field, further differentiating what NetSuite provides to the market from the old on-premise ERP systems of the past, systems that were difficult to access and actually designed to prevent the sorts of online commerce interactions customers expect from a modern, mission-critical business system.

Our business is also expanding geographically. Our opportunity is global, and in Q3, we saw strong new business bookings performance in North America and APAC, while EMEA basically held steady with last year's performance. On a revenue basis, APAC was our fastest-growing geography year-over-year and we also saw healthy growth in the double-digits in North America and EMEA.

And finally, our ecosystem is growing. Our SuiteCloud Developer Network now has more than 6,000 developers and hundreds of apps. In terms of the channel, channel new business grew almost 40% year-over-year, driven by strong performance in the channel, not only in North America, but also in EMEA and Asia Pacific. And today, we announced another series of big wins in the Microsoft, Dynamics, Great Plains and Sage reseller channels.

So we are very bullish on the future. While we are still in planning mode for 2013, I'm happy to give you a first glimpse of what we are seeing and what we plan to invest. And in fact, my comments this year are remarkably similar to the comments I made last year when we gave our first outlook for the current fiscal year, fiscal year 2012.

In 2013, on the top line, we are currently forecasting revenue of between $390 million and $400 million. On the bottom line, while we are still determining the exact level of investments that we will make next year, our bias is to make investments to take advantage of our strong market position and the growing demand for our solutions. Subsequently, our initial outlook is exactly the same as what we gave last year. Our current thinking is to increase our non-GAAP operating income in absolute dollar terms, while maintaining 2013 operating margins at somewhere around the same level we have for the last 2 years.

So we feel confident about the year ahead. Given our strength this year, I wanted to give you an idea of the good things that we think are in store for NetSuite, our customers and our shareholders in 2013. As is our practice, we'll give a full outlook for 2013 as a part of our next quarterly call.

So with that, I'd like to open up the call for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Greg Dunham with Goldman Sachs.

Gregory Dunham - Goldman Sachs Group Inc., Research Division

A couple of questions, first for Zach. The number of deals over $200,000 kind of jumps out at me as 60% year-over-year growth. What really drove that? In any verticals or any regions that you're seeing that? Or is there any profile of customer where that's been more successful? That would be my first question.

Zachary Nelson

Well, I think there are several drivers, Greg, and let me start by saying also, Ron and I are not in the same room, so hopefully we won't be stepping on each other too much with our answers here. So one driver, obviously, is the investment we've made really over the last year in our Enterprise sales organization is, obviously, paying off. And so hiring a team that goes after true Enterprise Sales and the related increases in average sales price associated with that is a driver. I also think that the metric is really an indication of the pricing power and the breadth of our suite gives us. And I'd say, just anecdotally, after we launched SuiteCommerce, I spoke with a couple reps about how SuiteCommerce might be impacting their deals. And again, this is all anecdotal, but in some cases they said it was doubling the size of the deal. So as we begin to bring out more and more functionality that enables more and more of our customers' business processes to be run within NetSuite, certainly the size of the deals will grow as well. So -- and then finally, of course, the move upmarket plays a role in this and that's not just in the enterprise, but larger midmarket companies as well. And so I think there are multiple factors, the functionality of our product, the investment in the Enterprise sales team and the general move upmarket that are driving those elements. The final piece I'd also say is, obviously, success with SIs, systems integrators, and the larger resellers is also playing into that.

Gregory Dunham - Goldman Sachs Group Inc., Research Division

And one quick one, Ron, for you. You had mentioned that billings, calculated billings is not a great read, but you didn't provide any color on caveats in terms of payment terms, early renewals. Should we read from that, that there wasn't an impact from those dynamics this quarter?

Ronald Gill

No, there was. It was not as dramatic if you -- last quarter, you may remember, I normalized what you would have seen on the face of financials as a 35% and I normalized it down to about a 30% based on those factors. If you do the same normalization this quarter, it'll normalize up just a little bit, so the number is a little bit higher than if I normalize it. And just a reminder of the things that we're normalizing for are the impact of FX and then really changes in contracted billing terms that affect the way a booking would get billed. So if last quarter I was normalizing down from 35% to 30%, this quarter, I would normalize -- if I were to do the same normalization, it would be slightly higher than the number you're seeing on the face of financials.

Operator

We'll move next to Jason Maynard with Wells Fargo.

Jason Maynard - Wells Fargo Securities, LLC, Research Division

I really had 2 questions. So the first one I wanted to drill on a little bit with you, Zach, was some of the commentary on the wins in these functional areas and get a little bit more color in terms of what you're seeing in your cycles as you're selling either PS capabilities or the commerce capabilities upmarket. And maybe talk a little bit about the dynamics in the sales process there. And I have a follow-up.

Zachary Nelson

Yes. So I think this is a natural evolution really of where we started with two-tier ERP. The early cycles around two-tier ERP were driven with the OneWorld product. The OneWorld product was something we introduced several years ago that, on the face of the product, really solved the multi-company financial consolidation problems that face multinational companies. That said, we've always talked about OneWorld, really not as a financial consolidation system but a business consolidation system. Because as you know, our strategy was to build a system to run a business, not a department. And so I think what you're beginning to see is customers figuring out they can not only consolidate their financials, they can consolidate business processes now across geographies. And that's really what's going on and you see it in the case of MRM where they're effectively consolidating how they deliver services across the world on a single platform. Where before they may have had several platforms in Asia, in the U.K., in Europe, in the Americas, now they have a single global platform, but really to manage the process of service delivery. And the other example that I gave was the commerce, the Ecommerce example, of a couple multibillion dollar retailers we signed during the quarter. As companies begin to look at how they advance their business quickly, they see their current infrastructure really as inextensible to solve new problems. And commerce is one of those new business problems and they can't wait 36 months to figure out how to integrate a funky website system like Demandware, back with their old ERP system like SAP. So they say, "Hey, why don't we platform this new aspect of our business, this very important new aspect of our business that we have to move quickly to, on a system actually designed to solve that problem?" And so I think that's what you're seeing. And certainly, SuiteCommerce and Commerce as a Service, I think you're going to see a lot of uptake of the system in that sort of application.

Jason Maynard - Wells Fargo Securities, LLC, Research Division

Okay. And the follow-up that I have for you is really around your operating margin commentary for next year. And I understand I may be an outlier on this one a little bit, but -- I appreciate that you're going to grow operating income, that you're going to keep margins flattish. But given the fact that you're seeing this such massive uptake of the new products, you're seeing the move upmarket really start to take hold, have you guys considered at all perhaps just flatlining operating income and just plowing the rest back into what appear to be fairly high return investments in distribution and product development?

Zachary Nelson

Yes, it's a good question and that's certainly what we're looking at now as we finish our planning cycle. And we're about midway through it, but we're still very early into it as far as making final decisions on where we're going to invest. Our belief is similar to yours and most of our investors, in that we want to see, in what ways can we invest to grow faster. And that's really what we're analyzing right now. I think the guidance we gave in terms of looking at the last 2 years operating margin and having it fall somewhere in there, really enables us a lot of latitude to make some decisions. And I would agree 100% with you. If you look at the dynamics of what's going on with NetSuite and what's going on in the marketplace, we're very confident in our ability to invest to take advantage of it. We didn't really talk about the productivity of our sales reps. We've added a lot of capacity this year. Productivity actually went up in Q3 compared to Q3 of last year, so clearly, we can add more sales capacity. You look at our development organization has grown something like 50% over the last year or 2, and that's certainly delivered great new products like SuiteCommerce and others that we can expand our marketplace with. Ron talked a little bit, gave a little bit of commentary on what we're doing in Q4 in fact to begin some of this early investment. A big piece of this investment is really doing a market study globally to see how NetSuite is perceived in the markets that we serve, everywhere around the world, as well as how we're perceived in the midmarket versus the enterprise. And we're getting some very interesting data back from that. But the net is when people know NetSuite, they are very favorably disposed to us from a brand standpoint. So to your point, the more deals we can get into, the more favorably disposed they'll be, the faster we'll grow. So marketing is certainly a piece we're going to look at heavily. And then finally, when you look at our competitive set -- and these are all the pros for investing more, to your point, Jason. Our competitive set is in complete disarray. Microsoft, once again, missed their shipment date for their supposed cloud version of one of their many ERP products. And I'm sure it wasn't a cloud version, it was a hosted version and they couldn't even get that out. So they're struggling and, in fact, they're more focused on hardware now probably than cloud-based ERP software. So that's a great opportunity for us. Sage is effectively dying. In fact, they're killing products as we speak, right? They're going to figure out how many products they can kill. And SAP is moving away from a suite-based approach to serving the mid-market and is starting to fragment which was what -- something that was already a failed product in Business ByDesign, now they're going to chop it up into little pieces and try to sell it. So I think if you look at our competitive set we have an enormous advantage. So yes, I think we're thinking along the same lines. We're trying to be rational with it, and we want to make sure the investment that we make as described, looking at the last 2 years operating income, really pays off. Now the thing that I would say about the payoff, you see a little bit of it -- you see some of it in what we said our guidance would be for next year, the $390 million to $400 million. And that's certainly better than what was out on the Street at $377 million, or $375 million, whatever it was. And so now the question is how much of that falls to the bottom line. And I think a $390 million to $400 million with an EPS of 20-something cents would make most of our investors feel better than a $377 million with, I think there's something like a 3 in front of it right now, $0.35 or something is the consensus. So I think we're thinking along the same lines as most of our investors, but we're going to finalize that discussion and certainly give you more color in the first quarter of next year.

Operator

Philip Winslow from Credit Suisse has your next question.

Philip Winslow - Crédit Suisse AG, Research Division

You guys saw an acceleration in just the calculated billings number in Q3 versus the first half this year, basically the exact opposite of what we've seen almost from the rest of the software companies out there that are seeing sort of a massive deceleration. I wondered if you could help to sort of what is driving that. You talked about OneWorld and like why do you think you're seeing sort of a difference there in terms of just your strength in larger deals and just uptake of two-tier ERP. What's driving that versus some of your competitors? And also, Zach, when you think about 2013, obviously, you've got your continued momentum in the products that have been around for a couple years now. How much of it is just continuing momentum in what you've been doing versus also starting to layer in some more SuiteCommerce?

Zachary Nelson

Yes, I think what's -- Phil, what's driving the business, particularly in the OneWorld area, is just speed. These larger companies are completely slowed down by these ancient pieces of software that they're running their business on. And for them to make any change -- let's just try to change our system to accommodate new business models or new business pressures, take months or years. And that's just -- you just can't live in that world anymore when your smaller competitors, many of whom are on NetSuite, can turn their business on a dime, turn their business system on a dime, explore new business models and not have their business systems hold them back. So I think the -- I sort of said it -- I said it at Suite World 2 years ago, we originally built the system designed to give the power of enterprise companies to midsized companies. What's happened now is enterprise systems want that NetSuite system but they want us to bring them the agility that we've also given these midmarket companies. So it's really about a rich application, and certainly we've been developing it now, investing a lot more so you've got incredible functionality, but now these large enterprises can turn their businesses as quickly as the small guys can. So I think if you look at a lot of the examples we've given in the enterprise, it really is about how can we respond to competitive pressures and change in the market with a business system that we can change in realtime. So that's a very big driver. And related to that, obviously, is the increased functionality we continually bring out. SuiteCommerce, I believe, is really a game changer in the sense of every business, not just technology companies, but every business now in those, they are a cloud company. They have to figure out how to reach their customers through the cloud, deliver new services, deliver new products. And as I mentioned, the systems they run their businesses on today, not only can't enable that sort of touch point with the customer, they were designed not to enable access. These things were designed to sit behind a firewall and be very hard to access. So their entire architecture is wrong for what the customer expectation is today. Our entire architecture happens to be right because we built a system that was accessible from anywhere on the globe, that had rights and permissions, so you could expose it to your customer as easily as you could to your controller. And so that architecture we've really doubled down on with the next-generation SuiteCommerce capabilities that allow our customers to extend their core business system. This is effectively -- there's no intermediary system now between our customer and their end customer as there has been in traditional website models, right? You put Demandware between SAP and try to expose data to your customers. This is live on their operational system to their customers, be it a business customer, be it a consumer customer, the transactions are happening live in their business system. The customer is looking at the business system, it just happens to look like a very cool website when they're doing that. So I think SuiteCommerce is just -- it's not a microcosm because it's a very big opportunity, it's really a macrocosm of what's -- the challenges we can help our customers solve in terms of what their customers expect of them.

Operator

Moving on to Laura Lederman from William Blair.

Laura Lederman - William Blair & Company L.L.C., Research Division

A few questions following up on competition. Can you talk a little bit about are you seeing Workday any more in financial deals, even in the pipeline? And then I have . . .

Zachary Nelson

Workday, we're not seeing anymore than we did in the last quarter. It's the smallest blip on our radar screen. It was a handful of deals literally in Q3 and, again, I think if you look at just their business model from the face of their financials, 300 customers paying them an average of $300,000 a year, primarily -- 99% HR-driven applications, that's a very different model than NetSuite with thousands of customers, smaller ASP and largely ERP-driven deals, financially ERP-driven deals. So I think we're very different companies. We have very different offerings and we're targeting very different markets. And as I've said before, they don't even have a direct sales force that sells below 1,000 employees. That's our sweet spot. So it's great to see another cloud company out there. It's great to see another successful cloud company talking about these opportunities, but there isn't really a lot of competitive pressure there.

Laura Lederman - William Blair & Company L.L.C., Research Division

And you talked about deals over $200,000, but what about multimillion dollar deals or million dollar deals in the quarter? And what that looks like in the pipeline as well.

Zachary Nelson

Maybe -- we'll talk maybe more about some deals like that as we summarize the year. The one thing I would say about the enterprise group is -- so we built an enterprise group, as you know. We invested heavily in it this year in terms of our sales capacity, that was the largest point of investment. And the pipeline there has been growing enormously. It grew 50% quarter-over-quarter. So in Q4, it's 50% larger than Q3. So and these -- and you're now talking about going up from $1 million to $2 million sort of pipeline. So that group is doing incredibly well and as I said, that obviously is a driver of these deals above $200,000. The other thing I would say, is I mentioned a couple of the SuiteCommerce deals, the 2 SuiteCommerce deals with multibillion retailers who are going to use NetSuite as their future Commerce as a Service platform, those were both brought to NetSuite by our big SI partner. So you also see that component working in the enterprise as well.

Laura Lederman - William Blair & Company L.L.C., Research Division

Can you talk a little bit about your product suite and would you see you making product acquisitions going forward to add functionality? Or do you feel that the suite is where you want it to be? So if you've seen such a massive consolidation out there and you guys have been doing more internally?

Zachary Nelson

Yes, I think there are a couple of ways we look at acquisitions. One is in functional areas that might make sense, and certainly there are places in Ecommerce where you could see different capabilities plugging in. But you could also see it in the core product. For example, several years back, we acquired our fixed assets module. It was built by a partner on the platform, so it was built as if our developers built it. So the more that our developers build things on the platform, the broader the possibility of perhaps bringing those functions in from a horizontal standpoint. So we certainly look at extending the solution from a horizontal ERP functionality, and where it makes sense we do those. Those tend to be fairly small. The second area we spent a lot of time looking at is in the verticalization of the suite. We have some natural verticals beginning to emerge. If you look at, we did an announcement today with a major clothing company, IBEX, out of Colorado. So we actually have a lot of clothing companies using NetSuite. So perhaps there are things we could do there for apparel manufacturing and apparel companies that might make sense to extend the solution for those types of companies. So we begin to look deeper into verticals as those verticals look deeper into NetSuite, quite frankly. And we'll be investing more in that both in terms of the analysis of the verticals and perhaps what we do in verticals in 2013.

Operator

Tom Ernst, from Deutsche Bank.

Stan Zlotsky - Deutsche Bank AG, Research Division

This is Stan Zlotsky sitting in for Tom. Two very quick ones. First one, on the Professional Services revenue growth, obviously a very impressive 50% growth year-on-year. How much of it is driven by you actually working in larger engagements as opposed to just the sheer number of engagements growing?

Zachary Nelson

I'll speak briefly to it and then maybe I'll ask Ron to add a little color. Much of it is due to larger engagements. Our hourly rate has been going up steadily over really the last year, and those tend to be larger engagements when that happened. And when the hourly rate goes up, the profitability of the services goes up. But Ron, maybe you can add a little more color on services.

Ronald Gill

Yes, I think Zach's point is right. Certainly with the larger deals, we have been able to get a larger rate. Also some of the very large implementations that we've started to do, not only do they come with a larger rate, but the Professional Services team can operate more efficiently working on a single project for a long time than they can on a bunch of smaller projects. So we've seen both utilization, that is the number of productive hours that somebody has, we've seen that go up, as well as the rate, and that's really been -- both of those 2 things together, I think have driven the revenue up.

Zachary Nelson

And the one other thing I would add, just more broadly about ecosystem. The other powerful thing that's beginning to happen as you see our partner channel begin to get scale and, certainly it's not just NetSuite that's gaining the benefit of these larger implementations or deeper implementations, our partner community -- in fact, I think in the last month you saw McGladrey buy Forward-Hindsight, which was a NetSuite partner. So we start to see those guys get scale. Another good partner, ERP guru, bought another services company Cloud Commerce. So you start to see in the NetSuite ecosystem, you're starting to get substantial services capabilities out there that's not just from NetSuite and that's a very positive thing for us and our model.

Stan Zlotsky - Deutsche Bank AG, Research Division

And then just one more. On the SuiteCommerce side, when you're coming into both large deals such as the 2 multibillion retailers that you just mentioned, as well as the smaller engagements, who are you usually running into from a competitive bake-off perspective?

Zachary Nelson

Well, it varies on the size of the company. You certainly see Demandware some, but again Demandware only has a handful of customers, right? 100 customers. And we have 2,800 websites running on NetSuite. So very different dynamics there. You see Magenta, which is an open-source product quite a bit but that's on-premise. The bloom is falling off the Magenta rose very quickly here as people struggle with not just managing it, but the complexities of the software. It's not particularly easy to use. So that's another competitor. And at the high-end, you see all sorts of stuff. You'll see IBM WebSphere, you'll see a variety of really consulting-driven products at the very high end. So it's an interesting landscape. The thing I would say is, the thing they all have in common is they are of a vast generation of technology. Their technology really designs for display. And I would -- I know Amazon announced today, but the interesting thing about Amazon, if you look at that website, it is not the sexiest website in the world. Why people love Amazon is really what happens on the back end. When you buy something, you know when it's going to be shipped, you know it's in stock, you know the price is right, you know the transaction is going to be done. Guess what? Those are effectively ERP functions. So NetSuite's got that stuff in spades, and not just in B2C but in B2B. And that's the other powerful part of this solution is terms-based purchasing. This customer gets better terms than that customer because he pays early. All of these B2B things, these are a natural feature of the NetSuite product. What we've done with the SuiteCommerce Enterprise product is now brought that incredible Amazon.com like back end, which ensures an incredible buying and shipment and delivery experience, with now a front end that rivals any front end. The ability to support any device, control every pixel on the screen. And so people often discount the importance of the back end in commerce. Our customers don't. But you look at a Demandware, they don't even have order management as far as I can tell. How the heck do you have an Ecommerce platform when you have nothing that takes an order? That's just a display system. And so that's very typical of all of these products is they tend to be focused on the display. They do nothing to solve the purchasing part of the equation from a sense of how do I deliver against the promise of that pretty picture on the screen? NetSuite's the only company that has both of those things together.

Operator

And your last question today will come from Brendan Barnicle from Pacific Crest Securities.

Brendan Barnicle - Pacific Crest Securities, Inc., Research Division

Zach, you mentioned how the quarter was sort of more back-end weighted, which is fairly typical. Did you see any difference as you headed into October? Any -- we've heard some companies talk about some deceleration that they saw in September as in that was then sort of troubling out there. They tended to be from some of the bigger bellwethers. So I was wondering if you saw any of that?

Zachary Nelson

No, I think it felt like a normal Q3 with that normal sort of end-of-quarter seasonality, and didn't feel any different. Obviously it was a good quarter for us even with that seasonality. And looking into Q4, I'd say the other piece of that puzzle is how does Q4 look, and certainly our pipeline looks very strong, lots of coverage for what we have to do in Q4. Of course, Q4 still has to happen. And we've certainly seen the traditional software vendors who really are cloud-based struggle with their quarters. So, of course, we have to close all the business in Q4, but we're pretty optimistic based on what we saw -- what we've seen to date through Q3 and certainly, the coverage we have in the pipeline going into Q4.

Brendan Barnicle - Pacific Crest Securities, Inc., Research Division

Great. And then as you think about next year and the margin story, will gross margins improve any or should we think of them as sort of flattish as well?

Zachary Nelson

Let me pass that question to Ron to give a little color on the gross margins.

Ronald Gill

Sure. What I'm expecting next year in gross margins will be a picture, probably the shape looks similar to this year. And that is, I think we'll overall have probably improving Professional Services margins, but continuing this blend of Professional Services in the mix. And so I'm not expecting a dramatic change from what we're seeing this year. I guess I should point out that Professional Services margin this quarter, 13%, and I think that's -- probably for this year, we're going to see something in the 13% to 14% range. Last quarter -- and we had messaged that this would go down. Last quarter's 20% was something of an anomaly high. So I think we're at 13% to 14% this year. And then next year, I think the margin on recurring continues right where it's been for a while now at around 85% and we might see a little bit of improvement on Professional Services.

Brendan Barnicle - Pacific Crest Securities, Inc., Research Division

And then as we think about the other line items, if there were to be some improvement in margins next year, where would the biggest leverage points be?

Ronald Gill

I think that -- Zach talked about we're still in planning, we've got a lot of investment decisions to make for next year, and I think a lot of that is what's going to flow out of that discussion. So I think I'll say let's talk more about that on the next call.

Operator

We do have time for one more question, and that will come from Jennifer Lowe with Morgan Stanley.

Jennifer A. Swanson - Morgan Stanley, Research Division

I just had 2 questions for you. First it's a tactical question. Zach, I think in your prepared remarks you mentioned that North America and Asia-Pac did really well in the quarter, but it sounded like you were a little bit more mixed in terms of the performance in Europe. Obviously, we've all seen the headlines about the economy there, but just curious was it anything more than macro or was it just purely things are just slower there right now?

Zachary Nelson

I think it's a bit of macro, but I think there's a bit of NetSuite-specific detail there. We've really spent the last 6 months investing in a whole group of new folks in our EMEA operation. We've got a great team over there now. And so I think some of the changes we've made there will start to ripple through positively as we move into next year. I think Sage is enormously vulnerable in the U.K. I mean it's both in terms of their channel partners and again you saw some announcements today where, in North America, their channel partners and Dynamics' channel partners continue their move to NetSuite. But I think we have an enormous opportunity, particularly in the U.K. I think Sage is incredibly vulnerable. I think they have a -- they're killing products, they're not building products. And so I'm really excited about some of the things we're going to be doing in EMEA, and in particular in the U.K. next year.

Jennifer A. Swanson - Morgan Stanley, Research Division

And maybe just to finish up sort of a bigger picture question. You all have, obviously, been seeing increased traction in the enterprise space with two-tier. There's a few companies that -- like Workday or an Oracle that are starting to introduce the concept of SaaS into the full enterprise type scenario replacing at the headquarters level. Is that something that you could do in the future? Do you think there are structural reasons why two-tier might be the longer-term way to go and maybe there is resistance doing FASME [ph] in the headquarters? I mean are you starting to see that change at all, and how do you think about that in terms of your own strategy?

Zachary Nelson

Again, this gets to a very detailed answer that really is about what industries are the business in that you're selling to, what functionality do you have for those industries, so it gets pretty company-specific pretty quickly. That said, I certainly think two-tier deployments of NetSuite can ultimately turn into single-tier deployments. I think it's a much longer sales cycle to certainly try to go to the CIO and say, "You know that $100 million instance of SAP that you've told the board was really important to do, we think you should replace that with NetSuite for $5 million a year." That's a very hard sell for a lot of reasons, not because we couldn't perhaps handle the business process, but because of a lot of philosophical and cultural issues in that business. So I think, for us, the two-tier approach both from a subsidiary level, a financial subsidiary level, as well as from this new functional avenue, I think that's the way to go. It's far more greenfield and we're solving really a mission-critical business problem that all of these companies have. How do I get to China quickly? How do I get to Australia quickly? How do I change my commerce operations quickly? These are burning problems for them. Frankly, replacing Oracle in a $20 billion company is probably not top on their list, but around the edges of that, they have a lot of fires and NetSuite has a great solution to put out many of them.

Operator

And at this time, I would like to turn the conference back to Mr. Zach Nelson for any concluding remarks.

Zachary Nelson

Great. Well, thank you all very much for your time today. As you can tell, we're very excited about how we're hoping to finish the year here. And 2013 just looks like another great year. So we look forward to speaking to you during the quarter, and certainly as we announce our final results in Q1 of 2013. Thank you very much.

Operator

And that does conclude today's teleconference. We thank you all for your participation.

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