ServiceSource International, Inc. (NASDAQ:SREV) Q2 2016 Earnings Conference Call August 8, 2016 4:30 PM ET
Erik Bylin - IR
Christopher Carrington - CEO
Robert Pinkerton - CFO
Timothy Klasell - Northland Securities
Ed Maguire - CLSA
Good day, everyone, and welcome to the ServiceSource Second Quarter 2016 Earnings Results Conference Call. This call is being recorded. Erik Bylin from Investor Relations will be opening today's call. Eric, please go ahead.
Thank you for joining us today.
Before we begin I'd like to remind you that during the course of this webcast and call, we may make projections or forward-looking statements to reflect our views as of today and are based upon information currently available to us. This information will likely change over time.
By discussing our current perception of our market and the future performance of our company and our solutions with you today, we are not undertaking an obligation to provide future updates. We caution you that such statements are just projections and actual events and results may differ materially from what we discussed. Please refer to the documents we have filed with the SEC. These documents contain and identify important factors that could cause actual results to materially differ from those contained in our projections and forward-looking statements.
During the course of this call we will also be discussing certain non-GAAP financial results and projections. For all of these non-GAAP measures, we direct your attention to a reconciliation between GAAP and non-GAAP measures, which can be found in today's earnings press release, posted on the Investor Relations portion of the ServiceSource website.
And with that I'll turn the call over to Chris Carrington, ServiceSource's CEO.
Eric, thank you. Good afternoon, everyone, and thank you for joining the ServiceSource Q2 fiscal 2016 earnings call. I'm joined on the call by Bob Pinkerton, our Chief Financial Officer.
Today I'll provide you a brief summary of our Q2, 2016 financial results, share some color on our sales efforts and the market trends we are seeing and then turn the call over to Bob, who will cover our financials in more detail. We will then open the call for Q&A.
Q2 2016 represented our sixth quarter of driving improvement and the business for the team delivering revenue, gross margin and EBITDA that were greater than the upwardly revised guidance we provided on June 9, 2016.
I'm very pleased to report that Q2 2016 represented the first quarter in over two years where ServiceSource delivered year-over-year revenue growth. Revenues for the quarter came in at $62 million, reflecting a small increase over Q2 2015 and were coupled with expanding non-GAAP gross margins of 38.5%, up 460 basis points from Q2 last year. This was the sixth consecutive quarter of increasing gross margins year-over-year and further reflects our commitments to reach our target gross margins in the mid-40s.
Continued discipline around operating expenses drove non-GAAP OpEx as a percentage of revenues to their lowest point since Q1 2015, contributing to our third consecutive quarter of positive EBITDA and our most profitable quarter since Q4 of 2014. EBITDA for Q2 was $2.9 million and was the collective result of multiple quarters of improving new ACV, lowering client churn, increasing productivity and management discipline around operating expenses.
Additionally, we accomplished this while investing in our revenue-as-a-service platform, inclusive of our people, process and technology which forms the bedrock of continued sustainable improvement in sales, revenue, gross margin and bottom line profitability for the long-term future.
On the sales front, our performance was equally impressive as our team delivered unprecedented results. We closed 25 new transactions in Q2 across all five of our verticals, including three new logos. This set a record for the most wins in a quarter coupled with the highest win rate in ServiceSource history.
Compared to the first half of 2015, the new ACV we closed is up almost 90% this year. With churn in the middle of industry norms, we produced another strong net increase in ACV in Q2. The sales team also continued to drive strong additions to early-stage pipeline, so that we are well positioned for future quarters.
Our sales momentum reflects the strength of our value proposition in the marketplace which is resonating well across industry sectors and company sizes. To expand on this, let me share a little bit more color on three new logo wins.
The new clients we added in Q2 with annual revenues between $25 billion and $130 billion represent three different verticals, including industrials, hardware and healthcare life sciences, and result in an overall increase to our total addressable market. These new logos represent a considerable opportunity to grow, and we expect to sign new deals in each of them in the 2016, 2017 selling season. While these clients have very different business models they all face the same need to retain and grow revenue from their embedded base customers, which is where ServiceSource has been creating value for our clients for 17 years.
Each of these new clients choose ServiceSource for the same reasons our current clients trust us with $8 plus billion of their revenue. Our revenue as a Service platform provides rapid global scale across 40 languages to more efficiently produce greater revenue, deeper customer insights and stronger brand loyalty than any other alternative. We do this through the unparalleled expertise amassed over nearly two decades of operation and has built the seven [ph] capabilities well beyond conventional renewals.
Increasingly clients and prospects are looking to ServiceSource to help them transition from their traditional product-oriented model to a services and subscription business model where they maximize the economics of a life time customer relationship. Our focus is to engage our clients' customer base throughout their lifecycle in order to drive customer success metrics inclusive of higher retention, lower churn and increased services adoption.
Ultimately ServiceSource value proposition is our ability to cross-sell, up-sell, retain, renew and extend the life time value of customer relationships more efficiently with better outcomes and in-depth insights.
Beyond the three new relationships and because of our strong pipeline I feel confident our opportunity with new logo wins in future quarters remains robust. Part of this opportunity is the widespread transition to subscription revenue models. While broadly discussed in the software market we are also talking to companies in the hardware, industrials and healthcare life science sectors that are exploring subscription models to drive greater customer retention and ultimately lifetime economics.
Software companies are rapidly transitioning, their business models from perpetual licenses to annual subscriptions. Hardware companies are moving from on-premise components to digital solutions and cloud-based delivery. And industrial and healthcare life science companies are embracing the Internet of Things, utilizing sensors and real time data to evolve from historically selling products to now selling outcomes from everything from jet engine to medical devices and laboratory equipment.
ServiceSource's unique value proposition and solutions play right into this transformational trend that changes how companies capture value from their customers. While this shift requires extensive retooling within each of their organizations and functional teams, it also alters how companies must think about ongoing customer relationships. Whereas business previously focused on capturing, the majority of customer economics at the initial point of sales they will increasingly have to prove their value each year or each month or risk increasing annual customer churn.
We are increasingly excited about the opportunity that this industry transformation provides us. The revenue lifecycle management motions that are part of our revenues at Service platform, inclusive of onboarding, adoption, up-sell and cross-sell capabilities, among others are ideally suited to the massive shift to a subscription-based economy that is happening now.
With proprietary IP and custom-designed customer success motion tailored to this transition. ServiceSource can be a critical partner for more companies and industries that now have to ensure their products and services are driving ongoing value to their customers. Our work in this area is already producing results for clients and I'm excited about the growth potential in front of us.
In closing, given the trends and opportunities we are seeing in the marketplace combined with our strong results for the first two quarters we are reaffirming our full year guidance of increasing revenue, expanding gross margins, improved EBITDA and 10% ACV growth.
And with that I'll now turn the call over to Bob Pinkerton, our Chief Financial Officer. Bob?
Thank you, Chirs. Today I'll share our Q2 2016 financial results, give some color on the drivers of our business and provide guidance for the third quarter of 2016. As a reminder we have posted a presentation on the company website with the details of our guidance along with the GAAP to non-GAAP reconciliation of that guidance.
Our Q2 results reflect further improvement in the performance of our teams. Our revenue, gross margin and adjusted EBITDA, all came in above the updated guidance we gave on June 9. The investments we are making in managed services have started to translate into better revenue delivery at a lower cost and this resulted in a significant increase in our gross margin this quarter, which flow through to higher profitability. We still have investments to make in the business to drive further improvement. But it is rewarding to see these investments start to produce ROI.
Now turning to results; our revenue was $62 million, a slight increase from the prior year and above guidance due to better performance in the managed services organization. Non-GAAP gross margin was 38.5%, up 460 basis points year-over-year and above guidance due to higher revenue along with strong cost management in the quarter.
Moving on to operating expense and profitability; our non-GAAP operating expenses came in at our updated guidance for the quarter at $22.7 million, down slightly year-over-year.
Adjusted EBITDA for the second quarter was positive $2.9 million, well above the loss of $230,000 from the prior year and above our guidance of breakeven to positive $1.5 million. Our non-GAAP net income for the second quarter was $1.1 million or $0.01 per share.
Now turning to a brief review of balance sheet and cash flow metrics, DSOs in Q2 were 79 days, down from 83 days in the first quarter of 2016. Cash flow provided by operations was $6.8 million. CapEx was $9 million, which included $3.3 million in capitalized development, resulting in negative free cash flow of $2.9 million after adjusting foreign exchange.
Our CapEx is trending higher this year, due to increased capitalized development combined with spend related to overdue investments in IT and facilities. We expect this to trend down in 2017.
With respect to our stock buyback program, in Q2, we repurchased 430,000 shares for a total spend of $1.7 million, not including commissions equivalent to an average price of $3.86 per share. We subsequently ended the quarter with $194 million of cash equivalents and investments, down $4.3 million from Q1.
Turning now to guidance for the third quarter of 2016, we expect revenue for Q3 in the range of $59.5 million to $62.5 million, which is flat to up 5% over the same quarter last year. We expect non-GAAP gross margins in the range of 33% to 36% in the third quarter compared to 32.4% in the year ago quarter.
We are forecasting non-GAAP operating expenses in Q3 of approximately $24 million. The sequential increase of around $1.3 million for Q2 is due principally to increases in personnel costs and investments in growing the business.
As a result, in Q3, we expect adjusted EBITDA to come in between negative $2.5 million and positive $500,000 and a non-GAAP net loss in the range of $1 million to $2.5 million or a non-GAAP loss per share of $0.01 to $0.03. We assume a basic share count of 86 million shares and a normalized tax rate of 40%. We're expecting free cash flow to come in at negative $4.5 million to negative $7.5 million for Q3.
And with that, I'll open it up for questions.
Thank you. [Operator Instructions] Our first question comes from Tim Klasell with the Northland Securities. You may begin.
Hey guys, Congratulations on the quarter. My first question is you mentioned on the call that your retention rate is hitting industry norms. I know over the long term, you have to want to get it above that. Do you think you're on-track for doing that sometime in short or medium term? And maybe you can talk to us what seems to be having the greatest effect out there.
Yes, Tim, thanks for the question. As we've guided to and then, shared our churn, or the inverse of that retention has been within industry norms, which we've always guided to are between 5% and 15%. In Q1, we tended to be at the low end of the range, and in Q2, we're at the mid end of the range.
So I think we're doing actually pretty well. I don't think you'll ever see us really come in and stay below 5%. That's just the nature of the space we serve and the services space we're in.
So feeling pretty good about it. Obviously, any contributor to something being above guidance of 15% would be a loss of a significant client. But I think we're doing all the right things now. We've been after the customer centricity initiative for well over a year. I believe it's become part of our DNA. This is a services type of business whereby sometimes you do have problems, but the good news is with the systems and technologies we've put in place we see those far in advance and we're able to get in front of them, fix the problem and retain the client.
Okay. Very good. And then sort of jumping over to your pipeline, you mentioned that, you have a lot of -- you have a healthy pipeline going forward. I know the three verticals you mentioned of the three new logos, are they similar, are they broader maybe give us sort of a color of what you see in your pipeline as far as the industries are concerned?
Yeah, sure absolutely great question. Well first and foremost I mean speaking to the pipeline, if we look at the pipeline currently right now today as compared to year ago, the pipeline is almost 50% larger. So it’s healthy from that standpoint and growing.
Second it has -- I was looking at this morning as we have our weekly call, we currently have 25 new logos in the pipeline. So I’ll tell you a year ago we might had three or four I mean and obviously, a year ago we were very focused on our current customers, getting them healthy, doing expansions with them. As we’ve accomplished that successfully we’ve now moved forward into really hunting new logos.
As to the three specifically, yeah we think a couple of them definitely start to open up new markets for us. We had good growth in Europe in the industrial solution space, whereby I’d say non-traditional player, signed on with this. It’s one of the larger companies of the $25 million to $130 million -- billion [ph] revenue companies and we’re starting a two country pilot and on that success we have the chance to expand to more than a dozen countries throughout Europe. And I think which again it opens up maybe some new market space here in this space.
The other two players, one's actually a medical equipment player in our healthcare life sciences group and so that enables that group to grow stronger and faster and then another one in the hardware side, is more in the telecommunication space and we had kind of been absent part of that space on the carrier side for a couple of years. We’re back in it and that represents big addressable market for us.
Okay great. That’s all I have. Again thank you very much.
Thank you. Our next question is from Patrick Walravens with JMP Securities. You may begin.
Hi guys. This is actually Matt on for Pat. Thank you for taking my question. You had a couple of key executive departures in the quarter. Just want to talk a little bit you could about the impact that might have had on your sales team and how you’re sort of moving forward without them? Thanks.
Yeah, thanks Matt. And thanks for joining the call today. It’s been really a seamless transition. First kudos, to Greg Hopkins who did a really nice job with transition, as he left at the end of June. But importantly really kudos to Ben Jennings who’s a 14 year experienced veteran of ServiceSource, who’s been running global sales, who’s running it on behalf of Greg.
He’s stepped in. He’s now Director, reports to me and we really have enjoyed and appreciated his kind of industry knowledge that he’s really bringing direct in the table. So that’s been a strong step in. And then Ryan Thomas, who’s a four year seasoned veteran with us, but 20 years in the industry, is running our Global Account Management. So I think we haven't missed a beat there and as I alluded to, with Tim’s question previously our pipeline’s never been stronger. We’ve gotten a number of new logos in there and I feel really good where we’re going.
To the second departure which was Joe Kovach, which was our Chief Transformation Officer. As I’ve described Joe is a change agent. He likes to come in, shake things up, put things together and then based on his career he tends to move on and go fix the next big problem. And he was able to take forward disparate IT organizations and create a single organization, make a number of leadership changes in that organization and get us on track with all of our migrations to single platform heading into 2017. And that organization now has now moved under Brian Delaney, our COO. Brian’s previous career, being COO for larger companies. He’s also a couple of those cases, owned by the CIO or CTO function. So the transition in a sense [ph] been really seamless and it’s worked well, if anything, it’s taking out a level and made us more efficient.
That’s perfect, and very helpful. Thanks guys, and congrats again.
Thank you. Our next question is from Ed Maguire with CLSA. You may begin.
Hi, good afternoon. I was wondering if you could provide some color on the strength in various verticals that you addressed. It sounds like those three deals that you called out were all from different industries but would be -- would appreciate any color you could provide on what verticals maybe performing well for you?
Sure. As I mentioned in my open commentary I mean we did have 25 transactions and why we highlighted the three new logos that we were excited about, with 22 other transactions that were customer or planned expansions. And so we really had great success across all five of our segments. The hardware technology segment has had challenges right as proprietary hardware providers compete against cloud providers and there seem competitive pressures and we've been able to step in with our clients, to really bring a strong customer success in selling force, which is why we are seeing expansions. So the hardware space is doing well for us.
In the traditional software space, increasingly our role is helping more of our software clients move from perpetual licenses to the cloud and subscription-based environments. And it really allows us to also add in, as people move to the cloud our skills around cross-sell and up-sell, which is another way for us to make additional revenues on behalf of ServiceSource. So that continues to be a good market for us. We are still expanding with some of the traditional, I will SaaS cloud providers, still an area of focus for us, I would like to see us do a little bit better in that space in quarters to come. But we do have some activity there. And then like I alluded to in new logos we had progress in healthcare life sciences and then also industrial or information solutions.
Could you comment on the competitive environment, whether there has been any developments there of any note?
As it was noted last call we brought on Chad Lyne, our Senior Vice President of Strategy and Corp. Dev. It's really been fascinating as we've been studying the market and digging in, that we are finding us a broader set of competitors that I think we knew were there before but we've more solidified our view as to where we can go aggressively attack and pick up market share from, in many cases smaller competitors where we can bring our global scale to bear and win there. And in other cases, regional competitors. We found a few in Europe and that's actually helpful to us because it predefines the market and allows our sales teams to go aggressively after that.
What we still seeing to lack is a standalone large global providers like ServiceSource. So we still enjoy, that I'll say freedom to roam the globe and go after the deals that we think are most exciting and best leverage our capabilities as a global company and we just kind of move forward from there.
Great, and then lastly, could you comment on the progress that you've made, last quarter I know you had seen quite a bit of real, I guess, surprisingly good traction from your Philippines deliveries that are -- globally how do you feel about the positioning of resources in strategic markets and the progress that you've been able to make over the last say year or so?
Yeah. Great insight, Ed. We've actually had great success and kudos to Brian Delaney in the global sales delivery organization. Brian did an outstanding job of I would say human capital and redistribution around the world. We are seeing growth in markets like Liverpool which had been a long time coming to grow there. We are seeing growth in other domestic markets in EMEA and certainly in North America.
And what we are really excited about of course is the two new offices that we launched. The Philippines is now more than 200 people and if you recall we just started having operations there effective in February. So to get up over 200 people shows the some of the growth that's going on there or angling to where somewhere 215-300 total in the Philippines by the end of Q3.
And then in Sofia we are up over 35 folks, once again serving multiple languages out of Europe. And we think that will be up closer to 75 by the end of Q3. We have 10 clients in the Philippines and 5 clients in Sofia. So considering both those operations just started this year, we're really pleased with the success we've had.
Great. All right, thanks a lot.
Appreciate it, Ed.
Thank you. This concludes the Q&A session. I would like to turn the call back to Chris Carrington for closing remarks.
Thank you Shannon. We are very proud of our ServiceSource employees worldwide. They delivered their first quarter of year-over-year revenue growth in two years and they continue to improve productivity and continue to delight our customers. So I'm very pleased about that. Really excited about meeting the growing needs of the emerging customer success marketplace around the globe and think we are well positioned with an expanding solution set to serve that marketplace.
And then finally, we are positioned very well to deliver on our full year guidance and set up for even better 2017. And with that I thank everyone for joining the call and look forward to talking to you in days and months to come.
You are welcome. Ladies and gentlemen, this concludes today's conference. Thank you for your participation. Have a wonderful day. You may now disconnect.
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