Cerence, Inc. (CRNC) CEO Sanjay Dhawan on Q2 2020 Results - Earnings Call Transcript
Cerence, Inc. (NASDAQ:CRNC) Q2 2020 Earnings Conference Call May 7, 2020 10:00 AM ET
Company Participants
Richard Yerganian - VP, IR
Sanjay Dhawan - CEO & Director
Mark Gallenberger - CFO
Conference Call Participants
Christopher Merwin - Goldman Sachs Group
Jeff Van Rhee - Craig-Hallum Capital Group
Operator
Ladies and gentlemen, thank you for standing by, and welcome to the Cerence Second Quarter 2020 Earnings Conference Call. [Operator Instructions].
It is now my pleasure to introduce Vice President of Investor Relations, Rich Yerganian.
Richard Yerganian
Thank you, Andrew. Welcome to Cerence's Second Quarter Fiscal Year 2020 Conference Call. Before we begin, I would like to remind you that this call may involve certain forward-looking statements. These; statements are subject to risks and uncertainties as described in the press release preceding today's call. Cerence makes no representations to update those statements after the date hereof. In addition, we may refer to certain non-GAAP measures and pro forma financial information during this call. Please refer to today's press release for further details of the definitions, limitations and uses of those measures and reconciliations of non-GAAP measures to the closest GAAP equivalent.
Joining me on today's call is Sanjay Dhawan, Cerence's CEO; and Mark Gallenberger, Cerence's CFO. As a reminder, the only authorized spokespeople for the company are Sanjay, Mark and myself.
Before handing the call over to Sanjay, I'd like to announce a few upcoming investor events. We will be participating in several upcoming ones. All of them have been converted to virtual events. So the exact timing of our participation is subject to change. Please visit our Events page in the Investors section of our website for the most up-to-date information on our participation.
The conferences include the Craig-Hallum, Cowen and Baird investor conferences, the Needham Automotive Investor Day and Deutsche Bank's Global Automotive Day.
Now on to the call. Sanjay?
Sanjay Dhawan
Thank you, Rich, and welcome to everyone on the call. As you can see from our earnings press release, we had a fantastic second quarter. We set a record in the first half for total bookings, signed the 2 largest contracts in the company's history, announced several other important strategic wins and delivered financial results that exceeded most of our guidance metrics.
Compared to Q2 of fiscal 2019, our total revenue grew 23%. And while our gross margin was up slightly, on a non-GAAP basis, our operating margin improved 31%. Adjusted EBITDA margin improved 26% and earnings per share improved 39%.
But before I comment further on our strong quarter, I'd like to take a few moments to discuss a topic that is on everyone's mind, the impact of the virus on our business and how we are adjusting to it. At Cerence, we're lucky in that across our employee base we have had only 1 person test positive for the disease, and that colleague has since fully recovered. This is very good news because the first priority for me and my executive team is to ensure the health and safety of our employees. We have created a crisis response team that meets daily and is tasked with closely monitoring the situation across the world, keeping employees informed on the latest development and planning for the necessary actions to protect our employees' health and safety as we eventually return to working in our offices.
While the global mitigation efforts are having a positive impact in slowing the spread, it has also resulted in a severe disruption of global economic activity, forcing most businesses to suspend operations or at a minimum work remotely. We are fortunate that we can have a measured approach to returning to the office because as a software company, the transition we made to work remotely was smooth and well executed.
Internal analysis show that our efficiency as a company has remained in the 90% range, even with most of the company working remotely. Our China operations have already resumed normal activity, which is encouraging as we look to them as a blueprint for the rest of the company.
Unfortunately, for Cerence, as in almost every industry and company, the slowdown in the global economy will have an impact on our business. While Cerence delivered a strong performance for our fiscal Q2, based on the recent forecast from third party, the auto SAAR is expected to significantly contract in the near term before beginning to recover later in the calendar year.
In response to this forecast, we have been proactive in adjusting our business. Mark will elaborate more on the details, but we have taken a number of steps to reduce our expense run rate and convert cash. The actions we have taken will still allow us to focus on supporting our current business as well as invest in the key products and technologies that we expect to fuel our medium and long-term growth.
For example, our investment in our One Cloud connected platform and the development of new products such as Car Life remain fully invested as these are critical to the long-term growth of the company. While the coronavirus has recently had an impact on the overall business environment, Cerence has continued to make progress in areas under our control. Year-over-year revenue grew 23%, led by strong growth in our connected platform and professional services business.
These revenue streams have less dependency on auto SAAR compared to the license or edge product. Our connected revenue is only marginally impacted in the near term by COVID-19 because the vast majority of revenue associated with that business is the amortization of deferred revenue from our balance sheet.
The professional services growth is a leading indicator of future growth in license and connected -- cloud-connected business because they represent the engineering work our engineers are contracted for to bring a new car platform to SOP. We have had a series of important announcements related to new business, reinforcing our industry-leading technology and strong competitive position. You may recall that we announced on our last conference call one of the largest contracts in company's history with the European OEM. This quarter, we announced the largest booking in the company's history with a different European OEM for a contract value at $125 million for our edge solutions.
Subsequent to this booking, we also signed another record booking for $140 million with the same customer for our connected services solution. While an existing customer, these contracts extend our technology into a much broader range of mix and models. These deals reinforce the secular tailwind for our business, which is driven by the increased penetration of voice assistance and cloud-connected services technology in more types of cars each year. We have previously presented an expectation that 85% of the cars produced globally will have voice assistance, edge capability, and that 50% will have connected capability in 2023, up from 59% and 12%, respectively, in 2018. And contracts like this one gives us confidence in that forecast.
We had several other important press release over the last couple of months. We announced an agreement with Geely, a Chinese-based auto manufacturer who own Volvo. The press release announces that Geely will use Cerence ARK product across all their car brands and platforms. Cerence ARK is a turnkey automotive solution that packages the company's state of the art AI-powered voice assistant features, including wake-up word, automatic speech recognition, speech signal enhancement, natural language understanding and text to speech and offers them in an open, flexible and fast architecture with minimal development and deployment time. This was a strategic competitive win for the company.
We also announced that the Fiat Chrysler Automobile group has adopted our technology in their advanced Uconnect 5 global infotainment platform. This platform is scalable across all FCA brands, and Cerence is providing innovative voice recognition technology for this advanced system. Most recently, we announced Bean Tech, a strategic partner of Great Wall Motors, one of the largest car manufacturers in China will deploy Cerence ARK to build AI-powered voice assistant for all their cars. This was a significant competitive win for us and indicates our ability to win share in the important China market.
For the first 6 months of the fiscal year, our bookings represent a record in the company's history surpassing total bookings for all of fiscal year 2019. The message here is very clear. Near-term business conditions aside, Cerence continues to build positive momentum for the long-term growth of the company.
As we navigate these challenging times, we are dedicated to employee safety and equally to the ongoing support of our customers. We expect the next couple of quarters to present unpredictable business conditions from the perspective of the volume of the business and our ability to forecast it. Because of this unusual situation, we are withdrawing guidance we had previously offered for the full fiscal year 2020 and will not provide guidance for our fiscal Q3. Our decision is not taken lightly given our desire to be transparent as possible with investors. But we must acknowledge the uncertainty among our customers' business that makes it very difficult for us to predict our own in the near future. While we manage through the near-term headwinds, the long-term growth remains intact, driven by significantly shift happening related to how users interact with the car.
During lessons -- drawing lessons from those shifts, the automotive industry is in a transitionary phase with a trend towards reimagining the user experience into one that closely integrates the hardware and software and brings in new ways of interacting with the car that are not possible with hardware or software alone. Much like that iOS is known for in iPhone, there is a growing push for user experience differentiated by brand using advanced HMI technologies, such as voice, touch and gesture to enable a more natural user-centric design. This results in a creation of an ecosystem that is centered on the vehicle and its sensors and using data from those -- from these to create new experiences for the user. The result is a seamless experience for the user between the car and the home by integrating all their identities into car functionality. The goal is bringing all this together with continuous uptick and refinements to constantly delight the user.
I'm very excited about the opportunity for Cerence to be a leader and innovator for enhancing this user experience inside the car. Whatever adjustments we have made to accommodate current business conditions is in no way impacts our ability to support our customers or advance our role as a critical part of the digital ecosystem of the car.
I would like to turn the call over to Mark to review the financial results of the quarter. Mark?
Mark Gallenberger
Thank you, Sanjay. I'll first review the strong performance for the second quarter of fiscal year 2020 and then offer commentary on the steps we have taken in response to the impact of COVID-19 on our business. We will then take your questions. Because the impact of a virus didn't hit until late in the March quarter, we were able to deliver excellent results. As Sanjay mentioned earlier, we saw the largest bookings for the first six months in the company's history. In most cases, these bookings won't be generating license or cloud-connected revenue until approximately two years from now.
As you can see from the table, we exceeded most of the metrics that we provided in our Street guidance. Specifically, we exceeded guidance on revenue, non-GAAP operating margin, adjusted EBITDA and non-GAAP earnings per share. Our GAAP revenue for the quarter was up approximately 23% compared to the same period a year ago, led by a 55% year-over-year increase in our professional services revenue, which is a leading indicator of future growth potential for our license and connected businesses.
Our non-GAAP gross margin increased from 69% to 70% year-over-year. However, our gross margin came in slightly below our guidance range of 71% to 72% due to product mix, which was led by higher-than-expected pro services revenue, which is lower margin than our license and connected products. Our non-GAAP operating margin was 31%, up from 23.6% in the same period a year ago. Adjusted EBITDA was up 55% to $29 million, compared to the same period last year, and our non-GAAP earnings per share was $0.43, up from $0.31 in the same period last year.
Our accounts receivable balance increased by $27 million from the prior quarter, resulting in a negative cash flow from operations of approximately $10 million. The increase in AR is attributed to onboarding customer transition issues from Nuance to Cerence, and also due to some stretching of payments by our customers late in the quarter. Although our CFFO was below our internal target for the quarter, we've had record collections during the month of April and collected over $30 million.
I'm confident that we will make up for our collection shortfall from last quarter. And I expect our CFFO to be greater than $20 million in Q3. This next table provides a breakdown of the different revenue streams that make up our business. And you can see that our overall license revenue was up 13% from the prior year while our cloud-connected revenue grew 23% and our professional services grew 55%. The growth in professional services is the leading indicator for the future license and cloud-connected business. License prepay contracts were $16 million in the quarter, up from $7 million in Q1. The sequential increase was primarily driven by a single customer that accounted for approximately 55% of our total prepay revenue.
Now because of the uncertainty of when auto manufacturers will ramp production and because most of our customers are no longer providing guidance for the remainder of the year due to the global economic impact of COVID-19, we are withdrawing our fiscal year guidance and not providing guidance for fiscal Q3. However, we continue to expect to outpace the auto SAAR as we have historically done so, but the auto SAAR forecast has been constantly changing, making it difficult to provide guidance at this time.
We believe that due to the secular tailwind driven by the continued penetration of voice assistant and cloud-connected technology into an expanding number of car makes and models, that we would expect to deliver approximately 10% to 15% better performance than the auto SAAR, meaning that if the auto SAAR is expected to be down 22% for the calendar year 2020, as indicated in the IHS April report, we would expect our results to be down in the 7% to 12% range over that same time period. The sensitivity of our business to the auto SAAR is also partially offset by the relative exposure of our various revenue streams.
For example, our professional services business is not directly linked to new auto production and is less likely to see disruption as our customers look to maintain their development schedules for platform upgrades. Likewise, our cloud-connected revenue is primarily driven by amortization of deferred revenue from our balance sheet. While connected billings will be affected by fewer autos being manufactured, our connected revenue in the short term will be minimally impacted.
A decline in SAAR will have the most impact on our license revenue, which is predominantly tied to auto production and accounts for about 55% of our total revenue. While a portion of the license revenue is from prepay contracts, the majority comes from royalty reports that we receive from customers telling us how many autos were produced in the quarter.
As a result of the COVID-19 impact has had on the global economy and in order to protect the long-term health of Cerence, we have adapted quickly and made adjustments to the business. These adjustments include a significant reduction in the use of outside contractors, a reduction in our workforce of about 5%, a 20% pay reduction for our CEO and a 10% reduction for the rest of the executive team for the next 6 months. A reduction of CapEx during the year from $35 million to $27 million, additional miscellaneous expense reductions, such as travel and other discretionary items.
The net impact is a reduction of operational expenses for the second half of the fiscal year of approximately $12 million and a CapEx reduction of $8 million. We believe that we have adapted our business to the current economic situation, while also not jeopardizing our long-term product road map and competitiveness. At this time, we are not planning any further reductions. Lastly, we ended the quarter with approximately $96 million of cash. Our cash position is strong, and we have not drawn down on our $75 million revolver, and do not expect to do so at this time.
Additionally, we require approximately $25 million to $30 million of cash intra-quarter to run the business. So we are in a very good position to ride out the economic headwinds. Our debt is approximately $267 million, and our leverage ratio is 2x versus our covenant limit at 6x. So the risk of tripping our covenant is highly unlikely. We have planned to refinance the debt, but unfortunately, market conditions deteriorated, and we have put that project on hold until market conditions are more favorable. However, once the refinancing is executed, we expect to save more than $5 million per year in interest expense.
In summary, we delivered an impressive quarter that reflects both the growth and operating performance potential of Cerence. We have taken the necessary steps to protect the balance sheet by quickly adapting our business to reflect the current environment. Our competitive position remains strong. Cerence continues to be recognized as the industry leader in voice assistance solutions, and our business model is designed to deliver compelling results. Once the near-term uncertainty is behind us, we are in a very strong position to return to impressive growth and profitability.
This concludes our prepared remarks, and now we will open it up to questions.
Question-and-Answer Session
Operator
[Operator Instructions]. And our first question comes from the line of John Sager [ph] with Evercore.
Unidentified Analyst
I had a couple of questions. Just on the prepay strategy. You saw the benefit in the quarter. So two quick questions around that. Can you just talk about how we should think about the cadence of that coming through on a quarterly basis. And then if you could talk a little bit about how that drives the strategy? And then one more question. Can you just give an idea of content per vehicle on some of the highest end vehicles where both license and connected, something like VW ID, where it's got voice, light and interior and HMI seems to be pretty extensive. Can we get content per vehicle on those platforms to be as high as $20 per car?
Mark Gallenberger
Sure. So I'll take the first question as it relates to prepay, and then I'll have Sanjay chime in a little bit on the -- on your second question. So as it relates to prepays, they can be lumpy from 1 quarter to the next, as you can see the large increase from Q1 to Q2. As we had stated previously, we are looking to have prepays flat to slightly down from the prior fiscal year. Prepays last year ran around $43 million. Right now, between Q1 and Q2, we're at about $23 million. So we're probably a little bit ahead of plan as it relates to prepays. Right now, I just don't know exactly what's going to happen in Q3 and Q4. But we're probably going to be at that plan or maybe even above it at this point in time. And so we don't want to expand prepays in a significant way. But we do want to be conservative in terms of changing prepays from 1 year to the next.
One of the benefits that you know is that we do get these fixed contracts upfront which locks in a certain amount of licenses for vehicles that are going to ship in the future. And the other benefit is the fact that we do get the cash upfront, too. So in many cases, we'll get the cash within 30 to 60 days in many of the prepay deals, which actually would help some of our short-term cash flow as we go through this more difficult period. So there is some benefit to some of the prepays. So I'll turn it over to Sanjay to make other comments on your second question.
Sanjay Dhawan
Sure. Thank you, Mark. Just to conclude on the prepay discussion first. The prepays are initiated by the OEMs, mostly their purchasing departments do request for discount, each purchasing group in an OEM has yearly targets. It's the way the industry works and something that we have to also participate because purchasing departments typically have a target to achieve, and they are pretty diligent about it.
In Q2, at CES, I was there in that meeting when this discussion of -- with the purchasing department of one of our OEMs started, right? And what resulted into was the prepay numbers that you see on our financials. We try to control it as much as we can. But to work with the automotive OEMS, some of this is something that we have to participate in. And one of the conditions of any discount from our side is to basically get the cash upfront through this prepay mechanism.
To answer your first -- the other part of your question, which is about the content per car. At the Investor Analyst Day in February, we did communicate that we plan to -- our goal is to double the content per car, the revenue per car from where it is right now to almost double in the next 2 to 3 years. And we're adding other new products to enhance that. And so getting to roughly $15 to $20 per car is the target that we are definitely going towards. And the way we are going to basically meet that is the voice platforms has a certain ASP, but we are bringing in multi-modality interactions on -- and combining that with our voice platform. So combining a product called Cerence Look, gestures and other interaction mechanisms and bringing it all together to deliver and also realize higher revenue per car.
Unidentified Analyst
That's great color. So if I think about double as an average, is it fair to say then that some of the super premium could be quite high?
Sanjay Dhawan
I think the super premium will be in the range that you're talking about. But also, there is revenue on the cloud side as well, right? So there is more than the numbers that we discussed because there is a cloud and connected services component to it as well.
Unidentified Analyst
All right. And then just one more, if I could. You guys mentioned something about the cyclicality of the professional services division being a little less cyclical than traditional businesses. But will that go down with the furloughs in Q3? Because typically, you guys are on-site for those -- to generate those revenues, right?
Sanjay Dhawan
No. We are not on-site. We are doing the professional services part -- 90% of it happens in our own offices, our own labs. There was a little bit of an adjustment because of COVID-19 because even the lab access of Cerence was disrupted to some extent and many of our engineers took some of the hardware home with the permission of automotive OEM so that they can continue their work from home. So we don't expect major disruptions there. And we're certainly hoping that there would be some level of opening that we have already started in Germany and in some of our European offices so that the -- our employees can maintain the social distancing, but they can still come at odd hours in the labs to do the testing and the final tuning that takes place on the car and so on and so forth.
Operator
And our next question comes from the line of Chris Merwin from Goldman Sachs.
Christopher Merwin
Just wanted to ask about the guidance. Obviously, you've got a very strong backlog, and we see that amortize into revenue. So in terms of your, say, total revenue per given year, like how much of that is already known just based on the backlog you have, and how much is variable from new bookings ultimately coming through the P&L? Just trying to get a sense of the magnitude there, given the decision to pull guidance for the rest of the year?
Mark Gallenberger
Yes. So I can start with that one. As you know, our backlog is committed contracts. However, it's not committed volume. And so even though we do have a sizable amount of backlog and we can see into the future, understanding how that backlog converts into revenue is really a function of forecasts and actual auto units being manufactured. So that's what makes it difficult in short term to predict what those unit volumes and what those production units look like. And that's what makes it challenging. So we do believe that the backlog is still very strong and solid. But to try to understand how that's converting short term into revenue, especially as it relates to the licensing line, that gets to be quite challenging.
Christopher Merwin
Got it. That makes sense.
Sanjay Dhawan
Okay. Chris, let me just add a little bit more. Sorry, we're all remote. So there's a little bit of a coordination issue here between Mark and I. But just to add to that. The backlog, like Mark rightly said, there is a function to the auto SAAR, obviously, right? But we monitor our backlog with multiple different sources of information. Obviously, we get forecast from the OEM. We get forecast from IHS. And then we have our own kind of intelligence based on multiple years of history of working with various different OEMs to forecast what the -- how the backlog will convert to revenue. And although this Q2 was the second quarter as me as the CEO and as I was watching our forecasting and so on and so forth, we are very accurate in the forecasting, but the problem now is that looking forward for Q3 and Q4, because of COVID-19, the shutdowns at the factories and all that stuff and when the economy is different [indiscernible] at different times, that is kind of what's creating a little bit of a challenge for us to what otherwise was a pretty solid forecasting mechanism for us.
Christopher Merwin
Got it. That makes sense. And maybe just one more question as it relates to accounts receivable, Mark, I know you mentioned in the prepared remarks, some of the factors impacting that there. But I guess as it relates to payment terms, in particular, can you maybe talk a bit about what percentage of your customers are looking for some sort of relief on payment terms? How big of an impact was that in the quarter? And maybe also anything you can say about the potential impacts of that as well in the coming quarters?
Mark Gallenberger
Sure. Sure. Yes. I think everybody, including us, when it comes to the payable side of the balance sheet, everyone's trying to stretch, everyone through the whole supply chain. And so it wasn't so much looking for a permanent or even a temporary concession on payment terms. It was just things that we expected to come in the second half of March, and they just simply did not materialize. And since then, we've had a very strong April collections month over $30 million. And so a lot of those just came in, in the first week, second week of the quarter, of the new quarter that is. So I don't think it's necessarily going to be a permanent dislocation here.
But I just think with such a big change in working capital for many companies through the entire supply chain, everybody was scrambling to kind of stretch everybody else. And so there was just -- really just not so much that we could do to try to pull that in and just accept the fact that it's going to come in the first or second week in the new quarter. And that's what we're starting to see. So I think going forward, I think, hopefully, things will start to stabilize, and we won't have as much of that issue in future quarters. But as you know, most of our customers are large Tier 1s, large car manufacturers, and they do have the wherewithal to make the payments. So we're confident that the payments will be made. There's no question of that.
Operator
[Operator Instructions]. Our next question comes from the line of Jeff Van Rhee with Craig-Hallum.
Jeff Van Rhee
Great. Maybe a little different angle for me here. I think as it relates to the bookings, obviously, a phenomenal quarter. I'm kind of curious, you said most development efforts are continuing unabated even though production is off. But if you look at the pipeline after what you just booked, which was tremendous revenue, what's the depth of the pipeline look like now? And in particular, within that, can you focus on the flow of connected deals, the number of deals that are up for bid, win rates. I'm just -- I'm more interested in the competitive environment and bookings backlog environment.
Sanjay Dhawan
Let me take that. So the pipeline for new business remains very strong. Our sales team is very focused, very busy. We have tried to kind of adopt to the COVID-19, everybody working remotely. So we're doing a lot of our product capabilities and demos through video, a bit strange. Because normally, we would basically take the car in with all the new products running and show a live demo to our customers. But instead, now we're kind of using video and other mechanisms to kind of continue our sales conversations with various different customers. So our pipeline across all regions remains strong. We have not seen major delays of new platform deadlines that customers may be thinking about, right? There was -- there were a couple of weeks of kind of slowdown during late March, early April. But it has picked up.
And we're having multiple customer conversations. Just to give -- to reflect my -- yesterday, I had four customer meetings, yesterday alone, right? So in 1 day. So that hopefully tells you that there is plenty of activity from a new pipeline standpoint. In terms of the win rate and other part of your question, we do think that we have mentioned previously that we have a 90% win rate. And we try to monitor that very closely to make sure that we're aware of all the -- all RFPs, and we track it and so on and so forth. I think we're maintaining that leadership still -- that's the way I'm seeing it.
Jeff Van Rhee
Okay. Great. And then one also similar to that. The SaaS ARR focus before COVID hit or even post, I mean any other developments there? I know as you laid out your long-term model, you had some pretty decent aspirations there over the next several years of what you think that the SaaS business can become. Any updates or meaningful developments there since we last talked?
Mark Gallenberger
We are in discussions with about half a dozen OEMs about some of those products, the new products. We have created a dedicated team with a dedicated leader, who's going to be basically kind of focusing completely full time on to that SaaS ARR line that I discussed with all of you during our Investor Day. And we hope to shortly in the second half of this year and beyond come back with some more progress on that.
Operator
And I'm showing no further questions at this time. So with that, I'll turn the call back over to CFO, Mark Gallenberger, for closing remarks.
Mark Gallenberger
Okay. Well, thank you very much for everybody taking the time to spend with us this morning to discuss our results. And we really appreciate your time and interest in the company. As Rich had mentioned, we are going to be doing 5 conferences in late May and early June. So we hope to see you there virtually. Thank you very much, and have a good day.
Operator
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect.
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