ServiceSource International, Inc. (NASDAQ:SREV) Q4 2017 Results Earnings Conference Call February 12, 2018 4:30 PM ET
Erik Bylin - IR
Chris Carrington - CEO
Bob Pinkerton - CFO
Pat Walravens - JMP Securities
Good day, everyone, and welcome to the ServiceSource Fourth Quarter and Fiscal Year 2017 Earnings Results Conference Call. This call is being recorded.
Erik Bylin from Investor Relations will be opening today's call. Erik, please go ahead.
Thank you for joining us. Before we begin, I'd like to remind you that during the course of this webcast and call, we make projections of forward-looking statements that involve risks related to future events. We caution you that such statements are just projections, and actual events and results may materially differ from what we discuss. All statements made during the course of this webcast and call, reflect our views as of today and are based upon the 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. All projections and forward-looking statements should be considered in conjunction with the cautionary statements in the earnings press release and the risk factors included in our SEC filings. 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. Unless otherwise stated, financial measures discussed in today's remarks are non-GAAP and exclude restructuring charges and one-time gains from the sale of an investment.
For all of these non-GAAP measures, we direct your attention to a reconciliation between the 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.
I would like to touch on the transition to the new accounting standard, ASC 606 regarding revenue recognition. At this time we expect the effect of the new standard to be immaterial and as such do not expect to restate prior results. We have provided a description of how we expect the standard will affect us in the slides that accompany the webcast which should be considered forward-looking information subject to the above cautionary statements.
And with that, I'll turn the call over to Chris Carrington, ServiceSource's CEO.
Thank you, Erik and good afternoon everyone. I appreciate you taking the time to join us for ServiceSource's fourth quarter and full-year 2017 earnings call. On the call with me is Bob Pinkerton, our Chief Financial Officer.
We have a lot to share with you today and are excited to highlight multiple areas of positive momentum. Before diving into the specifics of the quarter, I think it is important to spend a minute discussing a few points about the encouraging signs we're seeing at ServiceSource.
Last December marked my three year anniversary at ServiceSource, the progress in the business is gratifying but it did not come easy. The turnaround took longer than we initially expected and some of the legacy challenges required a bit more effort and time than we anticipated. I am pleased with what we have accomplished especially considering where the business was just three years ago.
Over the past year we saw a strong evidence the strategic initiatives we implemented throughout 2015 and 2016 were taking hold. Existing client relationships were strengthening. Our pipeline of opportunities was expanding. Performance against key client metrics was improving. And sales results were growing 20 plus percent.
Unfortunately, many of these positive developments were masked in our P&L by three factors. First, was the ongoing effort to complete the shutdown and the exit of the legacy C&BI business. Second, was the continued growth of our offshore centers and third, was the client bankruptcy that created difficult comparisons throughout 2017.
I'm proud to state, as you can see from one, the combination of our fourth quarter financial results, two, the material long-term commitments multiple clients are now making to align the ServiceSource well into the future, and three our 2018 guidance which calls for revenue growth and acceleration beginning in Q2. We believe the inflection is here and the internal progress we saw over the past 12 months will now be clear to all stakeholders.
Turning to our Q4 and full year financial results. We had very strong quarter where we beat the top end of our guidance on every metric. On the revenue side, we executed extremely well on behalf of our clients driving higher sales, conversion and retention metrics that, in our pay-for-performance model enabled us to generate $66 million of revenue for the quarter. This exceeded the top end of our guidance by $2 million and the 13.6% sequential growth from Q3 2017 marked the highest sequential growth rate in the past three years.
Illustrating ServiceSource's operating leverage and cost discipline, the strong revenue performance in Q4 flowed through the P&L with a high contribution margin. As a result, non-GAAP gross margin of 41.8% was 230 basis points above the top end of our guidance. OpEx was $19.2 million or 29.1% of revenue.
Importantly, OpEx of 29% of revenue marks the lowest rate in our history as a public company and highlights the rigor and discipline with which our teams are managing and operating the business. On the bottom line, adjusted EBITDA in Q4 was $10.3 million or 15.7% of revenue which was $2.8 million spared in the top end of our guidance range.
And last but not least, the combination of higher profitability and improvements in working capital resulted in positive free cash flow of $9.7 million for the quarter. For the full year 2017, we delivered revenue of $239.1 million, gross margin of 37.5% and adjusted EBITDA of $19.9 million. Our focus on streamlining costs for profitable growth is paying off as gross margins have improved by more than 550 basis points since full year 2014, while adjusted EBITDA has favorably swung by nearly $40 million from negative $19 million in full year 2014 to positive $19.9 million in full year 2017.
Again, a real credit to the team as we've dramatically improved the cost structure, strengthened the health of our client relationships, and solidified the platform upon which we can now return to profitable topline growth.
Now let me review how we performed against our five internal strategic priorities for 2017. Our first strategic priority was to further accelerate sales and new logo momentum. On this front, I am very proud of our accomplishments. For the full year 2017, we closed 70 transaction. In Q4 2017 alone, we closed 25 transactions encompassing 18 expansions and seven new logo wins. Over the course of 2017, we signed 15 world-class brands to our new logo roster up from the 12 new logo wins from fiscal 2016 and the three we added in 2015. These new logo wins will be onboarded in the first half of 2018 and we expect them to contribute to our accelerating second half growth.
Beyond the 2017 sales results, we're also seeing a robust and expanding sales pipeline that should further accelerate our momentum going forward. We enter 2018 with the pipeline as materially larger as compared to a year ago. In addition to its overall growth, I'm encouraged to see a pipeline that is increasingly diverse with healthy mix of geography, solution and end market.
Our second strategic priority was to complete the shutdown and exit of the legacy C&BI business including the Scout business that was acquired in 2014. As you may remember, this segment contributed approximately $25 million of revenue in 2015. Our decision to shutter this legacy business created optical growth headwinds in 2016 and 2017 but unequivocally strengthened the long-term health of ServiceSource.
I'm pleased to report that we've completed this initiative and can declare the sizable revenue headwind is now behind us. As you can imagine there was a lot of heavy lifting throughout the organization to accomplish this. We had to transition teams, migrate data and technologies and good faith negotiated exits from more than 20 contracts. With this box checked, we're now a more focused and efficient tech enabled managed services business.
Our third strategic priority was to diversify the business to capture compelling higher growth opportunities in the market. We've spoken in the past about ServiceSource's transition from a renewals company several years ago to a more diversified platform serving companies across multiple growth industries all the world.
Exiting 2017 that transformation is starting to be more evident in the numbers. Our solutions around pure inside sales and customer success now accounts more than 10% of our revenue. While it's still early days, these solutions are growing over 50% annually and the market demand we are seeing is encouraging and compelling.
Beyond our diversification to these higher value solutions and services, we have successfully repositioned the business as a go to partner for large organizations and growth industries who need a solutions based partner to help grow their revenue. Entering 2018, 62% of our revenue is now in the cloud and software sector, 29% is in the technology hardware, and 9% is in medical device and diagnostic equipment and industrial IoT.
ServiceSource's presence with large global organizations is also worth noting. We now survive the top 10 cloud companies, five of the top 10 software companies and three of the top 10 medical device companies. While we count many market leaders as our clients, we have plenty of room to earn additional opportunities with existing clients, as well as with the 1,000 other companies we've identified as prospective clients in our addressable markets.
In addition to the solution and end market diversification, we've also recently dramatically reshaped the business of our global delivery footprint. As recently as two short years ago, 24% of our employee base was in lower-cost labor markets predominantly comprised of our workforce in Kuala Lumpur, as our offices in the Philippines and Bulgaria had just opened.
Today over 44% of our workforce is located in these three lower cost locations. We continue to see amazing quality and results from our offshore professionals and the investments we have made there are delivering a solid ROI while allowing us to target additional growth opportunities with many of our installed based accounts.
Our fourth strategic priority was to keep our clients at the center of all we do. The mission is of course open-ended but our client centric approach and focus on their success continues to pay off. In 2017 we recorded expansion transactions with 26 logos up from 21 logos in 2016. Our clients are entrusting us to manage larger segments of their customer base and to also handle more customer journey touch points via inside sales and customer success motion.
Another proof point that our clients centricity efforts are being recognized is the success our teams had with contract renewals and term extensions across our existing book of business. While we are of course excited by the opportunity to grow our client relationships, the increase success we're having transitioning clients with annual renewals into multiyear contracts speaks volumes about the value we add and the client care we provide.
To this point, I'm very pleased to announce that in the closing days of 2017, we signed two of our five largest clients to multiyear contracts of five years and three years respectively with the combined multiyear expected value of $225 million. Between these material multiyear contract commitments and other extensions across our installed base, more than 50% of our revenue base is now secured by multiyear contracts. This compares to roughly one-third just one year ago. These multiyear commitments provide ServiceSource with improved revenue visibility and predictability over a longer time horizon while also validating the value we provide to our clients and the strategic role we play in their businesses.
Our fifth strategic priority was to continue as disciplined stores of our capital and resources in our 2017 results demonstrate this. Our initial guidance for 2007 adjusted EBITDA was for $13 million at the midpoint. Through disciplined execution, we were able to deliver $19.9 million of adjusted EBITDA which was nearly $7 million or 53% above the midpoint of our original guidance. And based on the strong fourth quarter, I'm proud to say ServiceSource was also free cash flow positive for the year.
Our execution on these five priorities gives us confidence that we have reached an inflection point in our turnaround and that our actions over the past few years and particularly throughout 2017 have positioned us for accelerating growth and profitability. Looking forward to 2018, let me similarly share the five key strategic initiatives for our team.
Priority number one, deliver 20% plus year-over-year growth in both the number of new logos and the total value of closed sales. If we successfully achieve this objective, the stage will be set for 2019 growth that builds upon our expectations for accelerating second half 2018 growth.
Priority number two, continue to separate ourselves as the clear market leader for inside sales and customer success. We will look to build upon the strong momentum established in 2017 and we expect these higher growth solutions to account for more than 15% of our revenue by year end. Based on feedback from clients, we know that inside sales and customer success are key areas for our existing clients and growing pipeline as the ability to generate revenue in increasingly digital and subscription-based world is a priority.
Our clients are coming to us given the skill and talent level of our people, our best-in-class platform, our data model rigor and expertise and our proprietary high-performance selling processes and methodology. We are uniquely positioned in our markets as we bring predictive science to areas that are typically managed with imperfect art.
Priority number three, continue to expand the number of employees in our lower-cost labor markets. The productivity, performance, margin profile and above all else client satisfaction in our offshore locations warrants additional investment and growth. We fully expect to exit 2018 with more than 2000 employees there. It is also worth noting that we expect to increase our onshore population as more higher value business is onboarded.
Priority number four, clients centricity and success. This will always be a top priority at ServiceSource and we will always seek more valuable and intimate relationships with our clients. We've made sustained multiyear improvements in our CPTs or clients performance targets and will continue to focus on delivering the metrics and outcomes that matter adding new innovations and capabilities and driving ongoing efficiency and return to our clients investments with us.
As we deliver for our clients, we would also expect to continue the trend running multiyear contracts. As such we believe that by year-end more than two-thirds of our business will be secured by multiyear commitments.
Priority number five, two words profitable growth. We've demonstrated our ability to deliver on the profitability part of that equation, and now we have to get to the growth part. It won't be evident in Q1 because of the year-over-year comparisons that still included revenue from a client bankruptcy where our projections are to turn the corner on growth in Q2 and return the mid-single-digit revenue growth in Q3 and four. I look forward to updating you on these initiatives as we progress through the year.
Before I turn the call over to Bob, allow me to share some commentary in what I'm seeing and hearing in the market. A particular importance to me is the feedback and affirmation that the structural changes and strategic transitions we have made are fully aligned with the needs of our clients and where the markets are heading. We've improved our operating efficiency, cost structure and pricing. We've enhanced our delivery footprint, global coverage model and language capabilities. We have invested and enhanced data capabilities and further major innovations to our proprietary technology platform. And we have deployed new high-growth solutions that have extended and solidified ServiceSource's compelling value proposition.
Put simply, we help our clients find, convert, grow and retain their B2B relationships and revenue. Our solutions span the entire B2B customer journey to help companies more efficiently and effectively monetize their customer relationships at every touch point and interaction driving customer value, insight and growth that is top of mind for any company's C-suite and we do this at unmatched scale speaking more than 40 languages, selling to more than 170 countries and leveraging our best-in-class technology platform and proprietary data models that we have refined overall nearly 20 years history. To my knowledge and based on what we are hearing, ServiceSource delivers unique value that is compelling to the marketplace and our clients.
With that, let me turn the call over to Bob Pinkerton our Chief Financial Officer who will share greater detail on our Q4 and full year 2017 results and our guidance for Q1 and full year 2018. Bob?
Thank you, Chris. Today I will share our Q4 and full year 2017 financial results, and provide our outlook for the first quarter and full year 2018. As a reminder, we have posted a presentation on the company website with the details of our guidance along with a GAAP to non-GAAP reconciliation of that guidance.
In Q4, our teams exceeded expectations and delivered revenue of $66 million which was above the high-end of our guidance. At the same time, we diligently controlled cost to drive strong profitability. Gross margin was 41.8% also above the high-end of guidance.
Our operating expenses came in at $19.2 million, a decrease of 23.1% year-over-year as we saw the benefits of the strategic actions we took earlier in the year. Between cost of revenue and operating expense, we delivered on our commitments and improved our expense structure by over $7 million for the quarter compared to the prior year.
Adjusted EBITDA for the fourth quarter was $10.3 million or 15.7% of revenue up 82.2% or $4.7 million from the prior year and well above the high-end of our guidance. Demonstrating the efficiency and potential profitability in the ServiceSource model, an approximately $7.9 million of sequential revenue growth we delivered $4.6 million of incremental EBITDA for an effective 58% contribution margin on the incremental revenue. Our net income in the fourth quarter was $5.1 million or $0.06 per share compared to $0.02 a year ago.
I'd like to highlight a couple of points about our fourth quarter performance and our increasing efficiency. As you see we outperformed the high-end of our expectations across all metrics for Q4 driven by the higher revenue level and continued expense management. The high-level revenue was driven by stronger-than-expected year-end bookings by our reps across more than a dozen clients.
Increased phone activity, direct contacts with end-users, leverage of our technology platform and strong macroeconomic dynamics all positively impacted our performance. We were able to drive this higher production with our current staff resulting in higher gross margin. Importantly, with the operational improvement and the seasonal Q4 uplift bringing our quarterly revenue above $65 million, we are able to demonstrate leverage and scalability in the business in line with our target model. The team has methodically executed on improving the fundamentals of the business and a solid foundation is in place as we plan our return to growth in 2018.
Now turning to a brief review of the balance sheet and cash flow metrics. DSOs in Q4 was 77 days down from 82 days in the third quarter of 2017 and down six days year-over-year driven by strong collection. Cash flow generated by operations was $13.3 million which was our highest cash flow quarters since Q2, 2012. CapEx was $3.3 million which included $2.7 million in capitalized development resulting in positive free cash flow of $9.7 million after adjusting for foreign exchange.
We subsequently ended the quarter with $188.6 million of cash equivalents and investments up $8.8 million from Q3 driven by strong operating cash flow. Free cash flow came in approximately $9 million better than the high-end of our expectation driven by the higher EBITDA and better-than-expected working capital management during the quarter roughly 5 million of which was due to better collection of AR.
Looking back in the full year, our 2017 revenue came in at $239.1 million down 5.4% year-over-year due to the headwinds Chris addressed in his remarks. Our gross margin was 37.5% that less than one percentage point as we adjusted cost quickly to align with the revenue base while still investing to ramp strong new sales wins.
Our operating expenses were $77.6 million for the full year down 15.1% year-over-year. And with that our 2017 adjusted EBITDA improved 53.7% or by $7 million year-over-year to $19.9 million. CapEx was $17.1 million down 35% year-over-year which included $12.1 million in capitalized development resulting in positive free cash flow for the year of $3 million increasing our cash balance from $185.6 million at the beginning of year to $188.6 million at the end.
With that, let me now address our outlook for 2018. You'll see that we are providing specific guidance for the full year 2018 for revenues, gross margin, operating expense, earnings-per-share, EBITDA and free cash flow. Today and going forward on a quarterly basis, we will be providing guidance for current quarter revenues, EBITDA and EPS.
We believe that this set of guidance criteria represents what is typical for a company of our size and best give you our view of the important full-year performance expectations for providing needed color around the current quarter. As usual if our view of the future material changes either positively or negatively, we will let you know as appropriate.
Let me now provide our outlook for Q1 2018. We expect revenue for Q1 in a range of $53.5 million to $55.5 million. We expect adjusted EBITDA between negative $1.5 million and positive $500,000, and a net loss between $3 million and $1 million or a loss of $0.03 to $0.01 on a per share basis. We assume a basic share count of 90 million shares and a normalized tax rate of 26.5%.
With that, I would now like to discuss our outlook for the full year 2018. We expect 2018 to represent ServiceSource's return to growth with revenue coming in between $243 million and $246 million. While we will see the dip in Q1 that I've just highlighted given the client bankruptcy impact on the year-over-year comparisons, our new sales will kick-in to where we expect to see slight year-over-year revenue growth in Q2 accelerating to mid-single-digit growth by the end of the year.
We expect to continue to drive efficiency across the business in 2018 but please note our progress on gross margin will be obscured by the J-curve effect that results from client growth. Specifically, we make meaningful investments upfront when we ramp new sales wins in recruiting, in onboarding, in training and platform costs among others yet revenue often lags the spend by quarter or two.
Given the number and size of our win in 2017, ramping them early in 2018 will result in a full year of costs but we will not achieve full revenue run rate until early 2019. As a result of these growth investments, we expect gross margin for the full year to come in at 36.5% to 37.5%.
Below gross margin, we expect OpEx between $78 million and $80 million for the year which should result in adjusted EBITDA between $19 million and $22 million. We expect non-GAAP net income for 2018 between $8 million and $10 million or $.09 to $0.11 on a per share basis. Additionally, we expect 2018 CapEx to be between $14 million and $17 million which results in expected full year 2018 free cash flow between breakeven and positive $3 million.
We remain confident in our ability to maintain sufficient cash levels to pay off the convert balance of $150 million in August while still retaining plenty of cash to run and invest in the growth of the business.
With that, I'll hand the call back over to Chris.
Thank you, Bob.
In summary, ServiceSource is at an inflection point. We delivered a great Q4 and continued a track record of impressive cost discipline and margin expansion. Our 15 new logo wins during the year and the major multiyear contract renewals show that we are squarely aligned to the needs of the marketplace.
With our strong new logo wins and expanding sales pipeline no longer masked by the C&BI and client bankruptcy revenue headwinds that are now behind us, we expect ServiceSource to return to sustained profitable revenue growth.
On this point, when we exclude the revenue from these two exogenous events, our revenue in 2017 would have been approximately $225 million. When compared to our 2018 guidance of $243 million to $246 million, this implies an approximately 8% to 9% year-over-year growth rate.
Before we open the call for questions, I would be remiss not to recognize the more than 3200 sourcers around the world who have worked tirelessly to transform the business over the past three years but particularly in 2017.
From our front-line professionals to our managers and leadership team, they all maintained 100% focus on delivering remarkable outcomes for our clients and we now enter 2018 a stronger and better company that is capturing the opportunity in front of us.
With that, let's open it up for Q&A. Bob, before we open up for questions, let me turn it back to you to make one announcement.
Sure, thanks Chris.
I wanted to let everyone know on the call here that there was a typo on the original earnings press release that was sent out first thing today in the 2018 outlook section, the second last bullet in the last half of that sentence should read, non-GAAP net income per share of $0.09 to $0.11 not a net loss. That's the only change and you'll see that in the corrected press release that was sent out moments ago. Thanks Chris.
Thanks Bob. With that, Latif why don't we go open it up questions.
[Operator Instructions] Our first question comes from the line of Pat Walravens of JMP Securities. Your question please.
First of all congratulations on the quarter. Secondly, that some typo, I'm glad that was a typo, I couldn't quite figure it out. Thirdly, I guess moving on to substantive things. So, I think one big question Chris is, the bankruptcy is exogenous sort of though I mean over ServiceSource's history including before you, there have been a lot of lost clients for one reason or another, so how do you handicap the risk of further bankruptcies further churn in your installed base.
I think in two ways Pat. First off, starting with the good news that I shared in my opening remarks that we were able to secure two multi-year contracts with two of our top five clients a five year and three year respectively totaling $225 million our future revenue expectations, so we continue to focus I'd say increasingly on all of our top ten clients who signed multi-year deals which will provide even greater revenue stability to us going forward. And I think there was a second part of that question that I didn't hear?
Well, let me go little deeper. So there's of your top five, there are three others right, how are those looking?
I think it's fair to say, you can expect we're in conversation with all three of those to replicate the experience into a multiyear scenario. We feel like in our conversations with our clients it really represents not only the best interests of ServiceSource but for them as well as allows us to do longer term planning as it relates to resources and investments we make in a relationship. I think those are being positively received and it’s helpful to have two of the five behind us.
And then secondly I'll just ask Chris, what are you sort of personal top priorities for this year?
Yes, I think as I said in priorities in my opening remarks. This is a year to return to growth and while I list the number 5, I think it’s a critical one for us to meet to hit the investors’ expectations. I think the second one that I really call out of the five is really the - becoming the clear market leader in inside sales and customer success seeing how as I mentioned that these two solutions are growing over 50% annualized, you’ll become a more meaningful and significant part of our revenue stream in 2018 and beyond.
And more importantly because of a lot of the things that are happening in the marketplace around us, when large tech companies move from field sales organizations and centralize that inside sales and there's definitively a macro trend that's come out on that in fact McKinsey just wrote a big study last month in January. As they moved inside sales it becomes far easier for them to outsource that function to a partner like ServiceSource. So we see as a huge and growing market. So for us to make sure that we're the clear market leader, that's really important to me.
Last one which is - so the labor markets really tight, right and on one hand that it seems to me would make your offerings that much more attractive because it's hard for your customers to hire people themselves. On the other hand probably not that easy for you to find them either, so how is that playing out?
I would say two-fold, first because of how effective we’re at driving outcomes, I still believe the vast majority of our current clients and even those perspective ones look more towards the pay-for-performance model and the outcomes we can drive.
Back to the point, if they were hire the resource themselves and don’t drive the outcome based on the expense where ServiceSource we take on that risk and so it’s still a very attractive model and we’re able to - I’d say charge the appropriate commission rates for that outsourced function and be able to deliver it to onshore.
But additionally that’s to my other point that I made, our commitment to open our far shore labor markets two years ago in the Philippines and Bulgaria, I guess they're proving out nothing less than genius because today in the Philippines, we have 700 employees, we have nearly 250 in Sophia, Bulgaria. We have another nearly 700 in Kuala Lumpur and we expect in aggregate that we will be over 2000 by the end of this year. So, we’re able to fulfill a lot of markets demands by using the complement of our offshore strategy.
And then Bob a quick one for you, you mentioned that - so can you give us a little more detail on it, is it that simple or you just going to pay down or you considering options?
Right now, we're paying the debt down come August and as you can see from our numbers we finished the year with bit over $38 million in net cash and at this point our strategy is to pay down. We have more than enough cash to run the business and grow the business.
That’s a great thing about generating cash again. So congrats on that.
[Operator Instructions] As there appear to be no further questions in queue, I’d like to turn the call back over to management for any closing remarks. Gentlemen?
Latif, thank you for hanging it back. I'll leave everyone with the thoughts that, I’m feeling really good about the business and we’re definitely have hit an inflection point. The fundamentals of our business have never been better in the three years that I’ve been here. Our clients are more satisfied, our installed base clients are renewing more frequently, they are expanding, they are utilizing more than one of our solutions and they’re willing to sign multi-year contracts.
It’s clear our value proposition of inside sales, customer success and revenue retention is resonating with the marketplace. And last but not least the business is operating very effectively with our people, our processes and our platform and thanks to all of the ServiceSource employees around the world who delivered a great quarter. Thank you.
Thank you, sir, and thank you ladies and gentlemen. This concludes today's conference. Thank you for your participation. And have a wonderful day.