ServiceSource International, Inc. (SREV) Q2 2021 Earnings Conference Call July 28, 2021 4:30 PM ET
Elise Brassell - Head, Corporate Communications
Gary Moore - Chairman and Chief Executive Officer
Chad Lyne - Chief Financial Officer
Conference Call Participants
Josh Vogel - Sidoti
Good day and thank you for standing by and welcome to the Second Quarter 2021 Earnings Conference Call. [Operator Instructions] I would now like to hand the conference over to Elise Brassell, Head of Corporate Communications.
Thank you, operator. We appreciate everyone joining us today and welcome to ServiceSource’s earnings call to discuss our results for the second quarter ended June 30, 2021. On the call today are Gary Moore, ServiceSource’s Chairman and CEO and Chad Lyne, our CFO.
As a reminder, our SEC filings and the earnings release we issued yesterday after market close are available on our website at www.ir.servicesource.com. In addition, we have posted earnings slides to accompany our comments today. Shortly after this call, we will post an audio replay and a copy of our prepared remarks to our website.
Before we begin, I would like to remind you that during the call we will make projections or forward-looking statements that involve risks related to future events. All statements made during the call reflect our views as of today, July 28, 2021 and are based upon the information currently available to us. 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, including our report on Form 10-Q. These documents contain and identify important factors that could cause actual events and results to materially differ from those contained in our projections and forward-looking statements and we disclaim any duty to revise or update any forward-looking statements.
In addition, during the call, we will also be discussing certain non-GAAP financial measures, which we believe provide additional information to enhance the understanding of how management assesses the operating performance of the business. A reconciliation of the GAAP and non-GAAP measures can be found in the earnings release that accompany this call.
And with that, I will turn the call over to Gary.
Thank you, Elise and welcome everyone to our earnings conference call for the second quarter of 2021. It’s a pleasure to be speaking with you today and to update you on the progress we are making.
Our second quarter results highlight areas of acceleration in the business and we expect our trajectory to continue to improve in the coming quarters. We are confident in our strategy, our capabilities and are squarely aligned to our clients’ most pressing challenges and opportunities, and our focused execution is driving stronger outcomes. Last quarter, we spoke about the lingering headwinds caused by COVID-19 and I would be remiss if I did not acknowledge that it continues to have an impact in particular markets and geographies. Uncertainty persists, particularly in foreign markets, but on balance, the tone, commentary and outlooks from our clients has shifted more to the positive. And within the small-to-midsize segment that we primarily address for our clients, we are seeing encouraging signs that companies within this tier appear to be on relatively stronger footing compared to the start of the year.
We believe we stand to benefit as our clients and their customers continue to regain confidence. The work we have done over the course of the past 2 years has improved our ability to be more responsive to the needs of the markets we serve. We have enhanced our solution suite and go-to-market strategy to be more focused and effective. We have transformed our delivery model to be virtual-first and more digitally enabled. We have streamlined our organization for greater speed and accountability. And we have invested meaningful time, resources and capital to strengthen the foundation of the company to allow it to grow and scale more efficiently over the long-term.
The impact of these changes is now becoming more evident in our results. Our year-over-year and sequential revenue comparisons are moving in the right direction. Our sales engine is becoming more consistent and predictable in landing new logos and expanding the installed base. And our unwavering commitment to a Clients for Life culture is creating an environment, where our clients increasingly view us as a strategic partner and trusted advisor that can help them succeed on their own go-to-market transformations. Across the technology sectors we serve and the clients we support, we see and hear a recurring theme. In an era of premium valuations, intense competition and rapid disruption, it’s no surprise that the top-of-mind priority is growth. And not just faster growth, but also smarter growth. Growth that puts the customer at the center, built on a relationship and not a transaction.
Our integrated customer journey experience solution suite assists our clients in achieving this growth mandate, more effectively and efficiently. Our digital inside sales solution allows for identifying, qualifying, and converting more new customers, ensuring our clients recognize maximum ROI on their marketing and sales investments at a lower cost of acquisition. Our customer success and renewals solution enables our clients’ customers to recognize faster time-to-value, ensuring they use, consume, and buy more from our clients over a longer period of time. And our channel management solution supports our clients’ indirect routes to market, ensuring their ecosystem of partners and resellers are equipped to help our clients win and retain market share. Regardless of what solution we deploy for a client, we bring the power of humanity and personalized engagement to their B2B customer relationships. At a high level, that’s what our team of sourcers do every day at ServiceSource.
Allow me to spend a few minutes sharing some recent client stories. I think this will help make what we do a bit more tangible and better illustrate our ability to drive results in areas that are strategic to the health of our clients’ businesses. As covered in a recent press release, we brought onboard a great new client in the second quarter. This company is an industry pioneer and category creator and is widely recognized as a global leader in the cloud-based team collaboration and communication space. For born-in-the-cloud SaaS companies like this, growth rates are often 40% to 50% annually or higher, but maintaining that growth often puts tremendous stress on the post-sales organization.
Focus naturally shifts to serving and supporting larger enterprise subscribers, which typically results in higher churn and lower retention rates in the SMB tier over time. This client was facing a similar dynamic, but recognized the strategic imperative of better engaging with the smaller subscribers that had contributed to its initial growth and success. Over the course of a multi-quarter pursuit, we assessed their renewals performance baseline and structured an innovative solution with a compelling ROI. Signed earlier in Q2, we are now live supporting this client with a holistic program encompassing subscriber health checks, contract quoting, and renewals and extension services.
We are seamlessly integrated into the client’s customer success team to help build and protect their recurring revenue subscription stream during their pursuit of above market growth in the new digital work era. And although our initial deployment is on the smaller side, we are excited about the potential upside opportunity in supporting a company with more than 100,000 customers and run-rate revenues in excess of $1 billion.
Earlier in Q2, we also announced an expansion for a market leader in the cloud-based enterprise identity and access management sector. This example highlights that customer success is a global priority. Our initial deployment launched in early 2020, with our team managing an end-to-end customer success program to enhance the lifetime value of North American based customers, with $100,000 or more in annual recurring revenue. Our customer success managers assumed full accountability for these subscribers after the point of sale, with a robust playbook of proactive engagement touchpoints, ranging from week one welcome calls, onboarding calls and health checks to quarterly success meetings and business reviews.
Our building trust and fostering relationships throughout their first year as customers, our teams drove higher satisfaction and generated incremental up-sell and cross-sell opportunities, delivering a strong 90% plus net renewal rate across this important customer cohort. Through the practical demonstration of our brand promise of trusted business outcomes delivered, we were asked by our client to scale our methodology and expertise to support their growth and retention objectives in EMEA and Asia-Pacific and Japan, giving the relationship a truly global footprint. Once the expansion is fully ramped, we expect the value of this client partnership will increase approximately 50% over the contract’s 2-year term, providing a great example of us earning the right to land-and-expand based on our performance.
The final example I want to share highlights the market growth opportunity for our digital inside sales capability. Late last year, an executive we had previously supported at one company moved into a new role as Chief Revenue Officer at another organization that was growing more than 30% annually. Based on his prior experience with us and the results we delivered, this executive engaged us to deploy a digitally enabled inside sales motion. This would allow his internal team of sellers to focus on larger opportunities, while we would ensure that the rest of the pipeline and leads were appropriately covered.
Our initial launch delivered on the mandate to help this client win share and accelerate growth in the hypercompetitive cloud communications space. As we announced in a June press release, based on the rapid success of our initial deployment, we agreed to triple the size of the engagement. With an aggressive implementation timeline, we have now successfully ramped more than 50 professionals to support this client’s high growth ambitions. I share these success stories as I believe they are a direct reflection of the improved execution we are seeing across the business, spanning our go-to-market, client delivery, account management and other supporting teams.
We are operating more effectively using our proprietary high performance selling methodology, which our clients tell us is a unique differentiator for us in the market. Our client performance targets, which are robust operational KPIs aligned to our clients’ unique objectives, are at all-time highs. We are also engaging better with our client sponsors and executives using our Clients for Life mentality. This is best demonstrated in our recently completed client satisfaction survey, where our net promoter scores increased 17 points to all-time high records. Our progress in these areas has boosted our ability to launch new programs and expansions in green status and continue in a healthy relationship for the long-term. You can see examples of this progress in the business highlights from our earnings release.
On the sales front, we carried forward from the strong results we shared in the first quarter. On a trailing 12-month basis through Q2, our bookings were up approximately 7% compared to the prior trailing 12-month period. Our wins in the quarter were also broad-based across approximately one-fourth of our client base, including expansion wins in excess of $1 million each of expected contract value, with 3 of our top 10 clients. We did have several attractive late-stage opportunities push into Q3 and we look forward to publicizing and sharing these with you once we get them signed.
With respect to our installed base of clients, through the first half of the year, we had more than $70 million of contract value up for renewal and our teams did an extraordinary job executing on them. We successfully renewed or extended approximately 97% of this value. And when factoring in expansions that accompanied these renewals, our net retention rate was in excess of 100%. Client satisfaction and retention has been a key focus area for us and these outcomes are positive signs that our efforts are paying off. I am incredibly proud of our team around the world for the great outcomes here.
In closing, our results through the first half of the year give us confidence that we are on the right path, first to return the business to growth later this year and second to accelerate towards to our long-term financial objectives.
With that, I will hand the call to Chad to cover the financials.
Thank you, Gary. It’s good to catch up with everyone today and thank you for joining us. When we spoke with you at the beginning of the year, we shared our expectation that the first half of 2021 would have more pronounced challenges from a year-over-year comparison standpoint, with a return to growth in the back half of this year. The dynamics we spoke about and first half cadence largely trended as we expected, if not a bit more favorably. With two quarters under our belt, we are encouraged by the headway we are making in the business and our stronger positioning to capitalize on a large and growing opportunity for our solutions.
Now, let’s turn to our Q2 results. Revenue of $46.3 million was down $1.3 million, or 2.8% year-over-year, marking a sizable shift from the 10.2% year-over-year contraction we reported last quarter. Consistent with Q1, the new logos we won in FY 2020 contributed approximately 3% to our second quarter revenue. The single large client headwind that we have spoken about in past quarters continued to weigh on our results as we have not yet lapped the tougher compare. If you exclude that client from both periods, revenue in Q2 would have shown nominal year-over-year growth. This is also the first time since 2018 where we can report top line growth from Q1 to Q2, which tends to be a seasonally softer quarter. On a sequential quarter-over-quarter basis, revenue was up 2.9%.
Walking down the P&L, our second quarter non-GAAP cost of revenue was $33.2 million and non-GAAP gross profit was $13.1 million, or a margin of 28.4% of revenue, down $1.2 million or approximately 180 basis points year-over-year. As we previewed in our May call, non-GAAP gross profit margins were impacted by higher recruiting and personnel-related expenses as we added approximately 150 employees in the quarter to support new program launches and expansions, including the examples Gary shared in his remarks.
Non-GAAP operating expenses were $14.7 million in the quarter and represented 31.7% of revenue, favorably down $1.7 million, or 10.6%, year-over-year. Looking at both our non-GAAP cost of revenue and non-GAAP operating expenses, our combined spend in Q2 was down approximately $1.8 million, or 3.7%, year-over-year, driven in large part by our flatter management structure, lower facility-related costs, and travel savings enabled by our virtual-first operating model. These savings are also net of approximately $1.4 million of year-over-year foreign exchange headwinds in the quarter, approximately three quarters of which hit cost of revenue and one quarter of which hit OpEx.
At the bottom line, second quarter adjusted EBITDA was negative $200,000, approximately $300,000 favorable year-over-year. Our approach remains consistent here. We are intentionally choosing to not maximize profitability in the near-term given our conviction around high ROI investment areas that we believe will support the achievement of our growth and longer term model ambitions.
Turning to the balance sheet and cash flow highlights, we maintained a healthy cash and liquidity position. Strong working capital management was led by DSOs of 67 days, a very impressive reduction of 9 days year-over-year and a 2 day improvement sequentially from Q1’s strong performance. Cash flow from operations was negative $500,000 and CapEx, inclusive of capitalized internally developed software, was $1.1 million, resulting in free cash flow of negative $1.5 million. Through the first half of the year, free cash flow was negative $2 million compared to negative $5.7 million in the first half of 2020.
We ended Q2 with $34.8 million of cash, cash equivalents and restricted cash. As noted in an 8-K filing this afternoon, last week we paid off in full the $15 million outstanding on our 2018 revolving credit facility that was due to mature on July 30. Following that payoff, on July 23, we entered into a new revolving credit facility with Bank of America. This new facility has a 3-year tenor, a $35 million commitment, a $10 million uncommitted accordion, and bears interest at a rate equal to BSBY plus 2% to 2.5% per annum or an alternate base rate plus 1% to 1.5% per annum. We are pleased to welcome Bank of America as the new financial partner and to successfully put in place an attractive credit facility to support our growth and working capital requirements going forward.
In summary, we are pleased with our performance in the quarter and the progression of our results through the first half of the year. The strategic changes and long-term focused investments we have made throughout the company are beginning to enhance our momentum in the marketplace. We continue to see improvement in the trending of our operational KPIs, the health of our client relationships and the trajectory of our financials. We are mindful that economic conditions remained fragile and outlooks are uncertain in many regions throughout the world. That said, we remain focused on the internal factors we can control. We are committed to building on the areas of internal progress we see and believe we are tracking favorably to report year-over-year revenue growth in the third or fourth quarter.
With that, operator, please open the call for questions and then we will have Gary come back after any Q&A to close the call.
Thank you. [Operator Instructions] And our first question comes from Josh Vogel from Sidoti. Your line is now open.
Thanks. Good afternoon, Gary and Chad. A couple high level ones first, if I may. I was just, when we think about the marketplace and the opportunity out there, seeing other companies and peers are talking about how larger enterprises are increasingly turning to outsourcing for a whole host of services. So, I was just thinking outside of your traditional small and midsized segment, can you talk about what you are seeing in the marketplace and are you actively going after larger client sets at all?
Hi, Josh. This is Gary. Yes, I mean, clearly, there is opportunity that we talked about some near-term opportunity that we did not close in Q2, but hope that we will close here in Q3 and hopefully early in Q3. A couple of those are the larger clients that deals don’t necessarily start as the large deals, but if you look at our portfolio today, we already have the largest enterprise tech companies and some of the healthcare in our portfolio. So, I would just say that the opportunities continue. I think that the fact that we have expanded 3 of our top 10 with $1 million plus run-rate revenue opportunity is a good sign of that. So, there are still headwinds. I think, not the concern, but I think while we have growing optimism, we still know that there is a tough road ahead in the marketplace, not the least of which is pushed on by uncertainty around tax rates here in the U.S. COVID, just a number of different things that aren’t put to bed yet. So I would say that, from our point of view, we are very pleased with the pipeline that we have. And some of those clients are ones that heretofore weren’t that interested in outsourcing, but they see the opportunity to really accelerate their internal sales as well as utilize ServiceSource to drive not only customer success, but also go after untouched areas of their market opportunity. Let me let Chad add a couple of things here. He is also very, very close to this.
Yes, no, thanks, Gary. And Josh thanks for the question. I think maybe the only clarification to that I would add to your question is that as you think about our client base, by and large, all of that is what we would define as enterprise clients, so whether it’s a $50 billion in revenue company or a $1 billion in revenue company, most of those are enterprise clients. But I think as we talk about SMB or the SMB tiers, that’s the cohort of customers that we are serving on our clients’ behalf, so just wanted to clean up that distinction between those two. But as Gary said as we look at the marketplace in size that we see an opportunity of upwards of 300 to 400 companies that are squarely within our TAM, companies with $500 billion plus of ARR and again, more companies moving towards subscription based models and recurring revenue streams, where solutions are really resonating and with our current client base of new approximately 40 still see plenty of headroom there to run and penetrate within that market, while still growing and selling more into our current book of installed base clients like we highlighted on the call earlier. So, I would say generally would agree with your thesis and what you are hearing from other companies that by and large, with the recovery in the economy, with companies growing on stronger footing, I think they are being the arbiter and looking more aggressively at outsourcing when we have seen that in our pipeline and some of the wins that we highlighted this quarter. So, to Gary’s point, there is still a lot of uncertainty out there, but do feel good generally about the tone and the commentary and the broader velocity that we are seeing in the marketplace.
Thank you for the clarification and really good insights there. I guess, even to your point about general uncertainty out there as the Delta variant makes its way around the world, there is a prevailing theme. I know, we are still kind of early on in the earnings season here, but a prevailing theme is talking about a sense of urgency or pent-up demand with clients and their agendas today. So, I want you to get a sense of what you are seeing in your dialogue with clients and are you – and is this resulting in any notable compression in the sales pipeline as well as following a signed contract that the time it takes to ramp obviously talking about on new business?
Yes. So no, we are optimistic to be clear about that. We – our pipeline is as strong as it’s ever been in terms of opportunity. We have multiple pursuits underway. We have been very fortunate to in Q2 sign yet another new logo and the expansions that we talked about. I think the opportunity we have is being driven, but based on our performance we have an all-time high and net promoter score is up 17 points and that’s a record high. The customer performance targets and the focus that might not and then the delivery team has put on that is really yielding dividends for us from an expansion point of view as well as continued getting performance hit. So I think the confidence in the long-term and our ability to continue to return to growth has strengthened. And again, I keep underlining there are some still – some variables out there and some things that could hit us. But I think we feel very strongly about the opportunity and that opportunity is increasing.
Thank you. It actually leads into my next question. And your commentary about returning to growth, can you maybe ballpark for me the level of year-to-year growth we could see in the back half of the year and while you are doing it, can you remind me what drove the strong results in Q4 last year, and given that it makes for a tougher comp? And you think you will see your growth in Q4 as well. And it’s basically implying a meaningful lift from Q2 levels.
Yes. Go ahead Chad.
After you, Gary.
No, go ahead.
Okay. Josh, I think, we would try to avoid putting specifics on it as you think about Q3 and Q4. But just to kind of point back to what we did talk about coming into the year, as we set up the context that we thought the first half would be a tougher compare. One, because of some of the churn that we had late last year that would start to roll through from a revenue standpoint, the one large client headwind that we mentioned. And then maybe coming back to your first question, did see a strong recovery in enterprise IT spending early this year. But we knew that it would take or we suspected, it would take a number of quarters for that level of confidence in discretionary IT spend if you will, to come back into the SMB tiers that we serve. So, we have seen that level of strengthening that did contribute to some of the good progress that we made in Q2, but our view on the full year is still consistent with what we shared in February and May that we do expect to return to growth in the second half of this year. And obviously pushing as hard as we can and being prudent about doing smart deals, doing the right deals and executing on our install base, we have to pull that sooner rather than later. So, that’s probably about as specific as I want to get with that one, Josh. But I think our objective is not even just this year or the next few quarters. But doing things that are going to set us up to deliver on our long-term target model, which I think as you know, we have talked for a while now, by returning the business on a consistent, sustainable basis, to show 10% plus year-over-year growth. So, we think that the groundwork that we have laid over the past 2 years, the investments that we have made in the business, the better results we are driving for clients, better retention of our employees, all those different levers are putting us in that right direction and pleased with the shape and shift of the revenue trajectory that we have seen so far and look forward to that continuing up into the right.
I appreciate that. And I knew you aren’t going get too specific, but I couldn’t control myself, I had to ask. So, I got one last one here. The slide and your comments around the gross margin, there is some pressure there tied to the higher recruiting and personnel related expenses. Was that it or was the mix have any play in it? And then just lastly, how should we think about the gross margin profile of the business once you see some leverage from the recent investments, and a return to top line growth?
Yes, I can start off here.
I will let you finish this Chad. But I don’t think, well, I have said that incorrectly. Our long-term view has not changed. The long-term model that we laid out there and our ability to grow 10% plus, and drive 38% plus gross margins, non-GAAP gross margin, and drive either side in the 10% to 12% range, once we get to a higher revenue rate. We still believe strongly in that. And I think as we look at the impacts of this last quarter, some of that impact really came from the fact that we have signed some business, we did some very fast ramping. We – Chad mentioned, the one client where we more than tripled the amount of people we had on it. We were able to do that in a very short timeframe. But a lot of those expenses were ahead of where we started receiving revenue because of that fast ramp. And we had a couple of those. So, I am comfortable with making that kind of bet, because it’s long-term high value revenue. Chad?
Yes. Only a couple points I would add to that Josh is, Q2 does tend to be one of our seasonally softer quarters, both from a revenue standpoint and a margin standpoint. If you look back 2 years, Q2 of 2019, was about 28.9%. So, we are 50 basis points below that and about 30 basis points below what we got in Q1 of this year. So, we are mindful of it. I know that we do have a lot of wood to chop and are focused on the lever for pulling to set us up to get to that 38% that Gary mentioned. But a couple of the pieces there that that drove the marking this time Gary hit on the ramping that we undertook in the quarter. I think that will continue to put a bit of a drag on GP margins as we look over the next quarter or two quarters and again, good problem to have because we are driving growth and expansion. And so, we are going to make those investments to launch clients in green and set them up for Clients for Life where that you turned on that investment upfront is well worth it. So, we will continue to do that. The other pieces that are contributing to that a bit as you think through the year-over-year compare as well is last year, we had a grant from the Government of Singapore that on the full year was bought north of $1 million of a good guide from the expense standpoint. That’s largely gone down now as you know, as COVID has moved into the background a bit. So, we had about 100,000 of Singapore grant recognized in the first half of this year, compared to about 400,000 last year. So, that’s a bit of the headwind. And then the third piece, we have mentioned it briefly in my prepared remarks is FX has clearly been a headwind in the business as well from an expense standpoint. Our revenue is fairly naturally hedged as we do billing invoice, predominantly in USD, but given the scope of our international operations in eight different countries, a good amount of our expense obviously does have some exposure to ForEx, or FX swings and so. As we have seen strengthening of the euro, the British pound, etcetera, compared to where it was in the first half of last year. That’s had about a $1.4 million impact across both cost and revenue and backs in Q2.
Alright, great. I appreciate all those data points. Well, thank you for taking my questions. And I look forward to chatting with you guys soon.
I appreciate it.
Thank you for your question. And I am showing me no further questions. I would now like to turn the call back to Gary Moore for closing remarks.
Hey. Thank you, Justin. I really appreciate it. I will be brief in closing here. As you heard in my earlier remarks, and as highlighted in the financial results that Chad shared, we believe we are nearing an inflection point in the business based on three key points and I would like to cover those. First, we are going after a large and attractive market opportunity. Our solutions are squarely aligned to the needs in this market. And what we have to offer is a growing importance for high growth companies like the examples I shared earlier on the call. Second, the changes and forward focused investments we have made during the past 2 years are resulting in stronger and more consistent execution throughout business. As we said last quarter, it will take time for this to fully realize in our financial profile. But our results in Q2 are a good indicator of that positive shift. And third, the outcomes of our teams are driving and the relationships we have built are positioning us as a strategic partner with our clients.
While these companies each have their own unique challenges and opportunities, we are doing a better job earning their trust to support their most important objectives and strategic priorities. So, we are pleased with our gains through the first half of the year and remain super focused on the progress we need to achieve in the quarters to come. So, thank you to our stockholders for your continued support on our transformation journey. We look forward to speaking with many of you in the coming weeks. With that Justin, you may end the call.
Thank you, sir. This concludes today’s conference call. Thank you for participating. You may now disconnect.