PROS Holdings, Inc. (NYSE:PRO) Q3 2007 Earnings Call October 29, 2007 5:00 PM ET
Charlie Murphy - CFO
Bert Winemiller - Chairman, CEO, President
Adam Holt – JP Morgan
Tom Ernst - Deutsche Bank
Tom Roderick - Thomas Weisel Partners
Robert Schwartz - Jefferies
Good day, ladies andgentlemen, and welcome to the third quarter 2007 PROS Holdings, Inc. earningsconference call. (Operator Instructions) I would now like to turn the call over to Mr.Charlie Murphy, Chief Financial Officer and Executive Vice President. Pleaseproceed, Mr. Murphy.
Thank you very much. Good afternoon, everyone. Thank you forjoining us today to review our financial results for the third quarter of 2007,our first full quarter as a public company.
With me on the call today is Bert Winemiller, Chairman andChief Executive Officer. In today's conference call, Bert will make somecomments on PROS' performance in the third quarter, and I will provide thereview of the financial results. We will then open up the call to questions.
Before beginning, we must caution you that today's remarkscontain forward-looking statements. These statements are based solely on thepresent information, and are subject to risks and uncertainties that can causeactual results to differ materially from those projected in the forward-lookingstatements. Please refer to our prospectus, 10-Q and other filings with the SECand the risk factors contain therein.
Also, please note that a replay of today's webcast will beavailable in the investor relations section of our website.
With that, I'd like to turn the call over to Bert.
Thank you, Charlie and thanks to those of your listing toour call this afternoon. We are pleased that we exceeded our target metrics inour first full quarter as a public company. The third quarter of 2007 markedrecord revenue, strong operating income and positive operating cash flow. Themomentum we are building in the pricing and revenue optimization marketincreases our confidence and optimism about our growth prospects for thefuture.
Our confidence is supported by the fact that we haveunparalleled experience and expertise in developing high performance, real-timedynamic pricing technology; embedding world-leading science in our softwareproducts, our high-visibility revenue model and the impressive return oninvestment realized by our customers after implementing pricing excellence bestpractices in PROS' pricing and revenue optimization software.
The third quarter marked another very solid quarter forPROS, and we remain very confident in our future as a leading provider ofpricing analytics, execution and optimization software products, as you willsee from our outlook.
We achieved record levels of revenue, operating income, netincome and operating cash flow. Our third quarter revenue of $16.4 million wasslightly above the top end of our guidance, and was up 32% compared to Q3 of lastyear. $11.7 million or 71% of that revenue came from license andimplementation, which we recognize on a percentage completion basis; and $4.8million or 29% came from service and maintenance.
Operationally, our non-GAAP operating income was $3.3 millionand was up 53% year over year. Our non-GAAP net earnings were $3 million, up50% year over year, and $0.11 per share on a fully diluted basis. In addition,we will the increasing our guidance for the remainder of the year, whichreflects our confidence in the business.
These results reflect the PROS proven business model andPROS' high visibility revenue model. PROS does not recognize any revenue atcontract signing. The license and implementation revenue is bundled together,and the revenue is recognized using percent of completion over the six to24-month implementation period.
The power of pricing continues to get the attention of CEOs.More CEOs are recognizing that traditional cost plus and match the competitionpricing strategies cause unnecessary discounting and destructive pricingpolicies. A McKinsey study showed a 1% improvement in price translates into an11% improvement in operating profit, and pricing is the most strategic andpowerful tool available to management.
PROS' early years were focused on the airline industry, theearly adopters of science-based pricing optimization. Airlines have millions ofbusiness-to-consumer and business-to-business transactions that areindividually priced every day. PROS' high-performance, real-time dynamicpricing products deliver all of the relevant pricing information at the timethe price is quoted, the deal is negotiated and the sale transaction isactually made. PROS provides the pocket price, pocket margin, customerwillingness to pay, customer cost to serve, win-loss ratios, market price,stretch price and other relevant information, so our customers can maximizerevenue and profitability by using optimized prices.
PROS has successfully diversified both geographically andacross industries by providing software products that dynamically price eachindividual transaction, which is very different from static retail pricing.PROS has blue chip customers in each of our target industries: manufacturing,distribution, services, hotel, cruise and airlines. While these diverseindustries provide a wide range of B2B and B2C products and services, what theyhave in common is the need to individually price each transaction optimally anddynamically.
We are thrilled with our third quarter results. Thisachievement is the result of the hard work of over 300 employees of PROS whoare smart, dedicated people doing great things to bring pricing excellence andhigh value to our customers.
Now, let me turn the call over to Charlie so that he canprovide you with details on the financial highlights of the quarter.
Thanks, Bert. I willbegin with a look at our income statement for the third quarter, which ended September 30, 2007. Then I willprovide some commentary on the balance sheet and cash flow items beforeproviding you with financial guidance for the fourth quarter and for the fullyear.
As Bert indicated, we are very pleased with our performancein the third quarter. Revenue for the third quarter of 2007 came in at $16.4million, which is up 32% year over year and was slightly above the top end ofthe guidance range we provided in our last call.
Within revenue, license and implementation revenue, which isgenerally recognized as implementation services are performed on apercentage-of-completion basis, was $11.7 million or 71% of total revenue, andwas up 41% year over year. Maintenance, which makes up the balance of revenue,was $4.8 million, up 14% year over year. Note that we recognize maintenancerevenue ratably and that maintenance revenue commences following completion ofthe implementation of the software, and therefore has lagged the growth of ourlicense and implementation revenue.
Our revenue is geographically dispersed, because we sell oursolutions to a diverse base of global customers. Approximately 60% of ourrevenue was generated outside of the United States during the quarter, and 65% year todate. This is consistent with past experience.
On a non-GAAP basis, gross profit was $11.9 million,yielding gross margins of 72.2% in the third quarter. This compares to grossprofit of $8.3 million in the third quarter of 2006 or 66.5% of revenue. We arepleased with the improvements in gross margins.
Improvements in our implementation processes and thecontinued standardization of our products have contributed to improving licenseand implementation margins. As previously communicated, gross margins may varyfrom period to period, depending on factors including the amount ofimplementation services required to deploy our products relative to the totalcontracted price.
Margins have been improving; however, our guidance for thefourth quarter would not be based on increasing margins because while theoverall trends for gross margins are up, we can't be certain that thepreviously mentioned factors which contributed to Q3 gross margins will have animpact in Q4.
Non-GAAP selling, general and administrative expenses forthe quarter of $4.4 million were up 26% year over year. SG&A expensesincreased in Q3, largely due to increased marketing and personnel expenses andto public company costs we are now incurring. We also incurred lessSOX-compliant costs in the third quarter than anticipated. With recentregulatory changes, it became evident that we should delay the bulk of our SOXthird-party compliance program costs until recent guideline changes are betterunderstood. We anticipate that lower SOX costs than previously expected willalso benefit our operating income in the fourth quarter of 2007.
Non-GAAP R&D expense of $4.2 million was up 58% yearover year, as we continued to invest in our pricing software solutions. R&Drepresented 25.7% of revenue, compared to 21.4% of revenue in the third quarterof 2006, as our planned R&D investments continue to develop.
This resulted in a non-GAAP operating income of $3.3 millionfor the quarter and a non-GAAP operating margin of 19.9%. These results areabove the top end of our previous guidance of $2.3 million. This compares tooperating income of $2.1 million in the third quarter of 2006 and operatingmargins of 17.2% in that period.
In absolute dollars, operating income has increased $3.7million year-to-date 2007 over 2006, or 84%. The improvement in non-GAAPoperating margins from a year ago was principally attributable to higher grossmargins.
On a non-GAAP basis, other income and expense was a netinflow of $492,000 primarily interest on our cash balances. Note that our GAAPother expenses includes expensing $397,000 of deferred financing costs inconnection with the repayment of a debt facility that has been retired. Wereported on this during our second quarter call.
Our non-GAAP effective tax rate is 20% in the third quartercompared to 20% in the prior year. Excluded in our non-GAAP tax expense for thethird quarter of 2007 is a benefit of $1.1 million due to the reversal of avaluation allowance previously recorded against our deferred tax assets. Thereversal is the result of our conclusion that it is more likely than not thatthe associated deferred tax assets will be realized.
Our effective tax rate historically has been lower than thestatutory rate of 34%, largely due to the application of general business taxcredits. We expect to continue to benefit from these credits for theforeseeable future.
While we expect the effective tax rate to be approximately21% in Q4, it appears that in 2008 our effective tax rate will increase toapproximately 27% to 28%, due to the utilization of research andexperimentation tax credit carryforwards in 2007 and to the higher levels ofpre-tax income in relation to research and experimentation credits earned.
Non-GAAP net income of $3 million for the quarter comparedto net income of $2.1 million for the same period in 2006. Non-GAAP net incomeper diluted share was $0.11, based on 26.2 million weighted-average sharesoutstanding, compared to $0.10 per share in the third quarter of 2006. 2006reflects a lower pre-IPO share count of 20.9 million shares. 2006 earnings pershare would have been $0.08, rather than the reported $0.10, using the post-IPO2007 weighted average shares outstanding.
The previous information has been a report on our non-GAAPoperating results, because we believe that excluding certain non-cash itemssuch as stock-based compensation, deferred financing costs, the reversal of avaluation allowance against deferred tax assets and other one-time itemsprovides you the best indicator of the health of the overall business. Also,this is how we measure the success of the business internally.
That said, we appreciate that investors also need to analyzeour results on a GAAP basis, so we have provided a reconciliation of the GAAPresults and non-GAAP results as part of the earnings release.
Looking at our results on a GAAP basis, total expenses were$13.6 million for the third quarter, which included stock-based compensationexpense of $423,000. This compares to GAAP expenses of $10.3 million in thethird quarter of 2006. In2006, there was no stock-based compensation expense.
GAAP net income was $3.5 million in the third quarter,compared with $2.1 million in the third quarter of 2006. In addition, stock-basedcompensation charges of $423,000 our GAAP net income in the third quarterdiffers from non-GAAP due to the one-time expensing of deferred financing costsof $397,000 and a benefit of $1.1 million due to the reversal of the valuationallowance previously recorded against our deferred tax assets.
These costs reflect the difference between our GAAP andnon-GAAP results and totaled, after-tax, a $490,000 reduction to GAAP netearnings. Our third quarter GAAP diluted earnings per share was $0.13.
As I mentioned earlier, a full reconciliation of GAAP tonon-GAAP measures is provided in our earnings press release.
Moving to our balance sheet, we ended the third quarter of2007 with cash and equivalents of $40 million, which includes net IPO proceedsof $52 million excluding operating expenses. A portion of the IPO proceeds wereused to repay $20 million of debt in the third quarter.
Accounts receivable at the end of the third quarter were$14.9 million, a decrease of $1.1 million from the prior quarter. Tradeaccounts receivables DSOs were approximately 75 days, which is in line with ourtypical DSOs. Accounts receivable balances can vary in a quarter, based on thetiming of invoicing of milestone billings under our contracts, which again, canvary from quarter to quarter.
Deferred revenue at the end of the third quarter was $27.5million, compared to $27.2 million at the end of the second quarter. As withreceivables and cash flow, deferred revenue can fluctuate on aquarter-to-quarter basis, depending on the timing for milestone billings underour contracts. Because deferred revenue is not tied to total contract value, wedo not believe it is a meaningful forward indicator.
Additionally, maintenance revenue for the most part isbilled monthly, and as such generally has little effect on deferred revenue,even though it contributes meaningfully to overall visibility.
Let me now turn to cash flows. Operating cash flow in thethird quarter was $5.6 million, compared to $3.6 million in the third quarterof 2006. As with receivables, there is variability in cash flow, as it isimpacted by the timing of invoicing for milestone billings under our contracts,which can result in some quarter-to-quarter lumpiness. Capital expenditures inthe quarter were $1 million, which includes expenditures to expand our existingfacility.
Overall headcount at the end of Q3 was 337, compared to 280 a year ago, as we continue toincrease is staffing throughout the organization in order to support ourcontinued growth.
Now, let me turn to our guidance for the fourth quarter andfull year. For the fourth quarter of 2007, PROS anticipates total revenue inthe range of $17 million to $17.3 million, representing a growth rate of 30%from 2006, at the midpoint of our guided range.
We are projecting non-GAAP operating income of $2.9 millionto $3.2 million, and we are anticipating non-GAAP net income of $2.6 million to$2.9 million and non-GAAP diluted earnings per share of $0.10 to $0.11, basedon an estimated fully-diluted share count of 26.4 million shares. Theearnings-per-share guidance reflects an increase in diluted shares outstandingcompared to Q4 2006 of 5.1 million shares from shares issued at the initial publicoffering. The GAAP EPS guidance in the press release was stated as $0.08 to$0.009. It should have been $0.08 to $0.09. The press release filed in the 8-Kwill be corrected.
Non-GAAP operating income and net income for the fourthquarter excludes estimated FAS 123 R stock option expense of $0.5 million. As apublic company, we are now incurring public company costs, including higheraudit and legal fees, directors' compensation, directors' and officers'insurance and SOX compliance costs. These costs, including our expectation ofreduced near-term SOX compliance costs, have been factored into the operatingincome guidance I just provided.
Using the guidance figures I just provided for the fourthquarter, for the full year 2007, we expect total revenue in the range of $61.3million to $61.6 million, or a growth rate at the midpoint of 34% compared tothe prior year.
We are projecting non-GAAP operating income of $11 millionto $11.3 million. We are projecting non-GAAP net income of $9.6 million to $9.8million and non-GAAP diluted earnings per share of $0.41 to $0.42. Non-GAAPoperating income and net income for the year excludes estimated FAS 123 Rstock-option expense of $1.4 million, expensing of deferred financing costs of$400,000 and a benefit of $1.1 million, due to the reversal of the valuationallowance previously recorded against our deferred tax assets.
Diluted shares outstanding for the year are estimated at23.4 million.
This fourth-quarter and full-year guidance is based on ourcurrent expectations, given our sales pipeline at this time. With continuedbusiness momentum, we are increasing our full-year bookings forecast for 2007to a range of $42 million to $44 million.
With that, let me turn the call back to the operator so wecan take your questions.
Your first question comes from Adam Holt – JP Morgan.
Adam Holt - JP Morgan
Congratulations on the quarter. My first question has to dowith the raised bookings targets for the year. I was hoping you could give alittle bit more detail as to whether or not it was strength of deal closures inthe quarter that gives you that confidence? Is it about the pipeline for thefourth quarter, a combination of both? Maybe a little bit more detail therewould be terrific.
What we've done is the pipeline opportunities remain strong,and our close rate in Q3 was probably a little better than we had expected aquarter ago. If you look at our overall pipeline, it's about the same level ofrobustness as a quarter ago, but we have been able to hard circle a few dealsearlier than we had thought, which certainly has built our confidence for thefull year. So with that, we brought the guidance up from $38 million to $42million to $42 million to $44 million. It really is confidence in bookingsclosed year to date that gave us the ability to raise our guidance.
Adam Holt - JP Morgan
Another factor behind bookings is obviously yourdistribution. Could you update us as to where you are with your direct sales atthe end of the quarter? How do you feel about productivity related to some ofthe headcount adds that you brought on over the last quarter or two?
Why don't I take thisopportunity just to review the bookings and contracts, and how we look at themand how we manage the business and developed a proven track record over thelast nine years. There are really three key factors related to bookings andcontracts. One is the high-visibility revenue model; second, the high averagesales price and then the mix of business and diversification. These hitdirectly to the question.
The high-visibility revenue model, we do not recognizerevenue when the license and implementation contract is signed, so there is nomotivation to discount or agree to onerous terms in a contract at the end of aquarter. We do not try to drive bookings or number of contracts in a quarter sowe can report the numbers and we have chosen not to disclose those numbers.
Our experience shows that managing to an annual bookingsgoal is the best way to achieve our target revenue growth with strongprofitability. Also, we recognize revenue over the implementation period of sixto 24 months. So bookings in a quarter are not unnecessarily a good indicatorof future revenue timing.
The next item is the high average sales price. Our averageselling price of a deal is high. PROS' pricing and revenue optimizationsoftware products are purchased by the CEO and CFO. The ASP is high, muchhigher than most software product purchases, and actually require in most casesCEO and CFO approval. This is good, because we're not automating the currentprocess.
When you look at spreadsheets and cost-plus and match thecompetition and those destructive practices, clearly you want CEO and CFO sponsorshipand leadership and that becomes a key to achieving pricing and revenueoptimization success. So, if we start discounting to achieve a bookings orcontracts quarterly metric, we definitely would be sacrificing our long-termgoals for short-term results.
The final is the mix of business and diversification. Thepricing and revenue optimization software products market is still in its earlylifecycle. The first mover, innovative CEOs are driving the adoption rates andgrowing momentum. These adoption rates can vary across our target industriesfrom quarter to quarter, so reporting bookings and number of contracts eachquarter by industry might give investors the wrong impression.
Also, we have effectively diversified our business from ourearly years of focus on the airline industry to our target industries. Ouryear-to-date 2007 non-airline license and implementation revenue was 66%. Inthe third quarter, 69% of our license and implementation revenue was frommanufacturing distribution services, hotels, cruise. So we are very pleasedwith our global diversification and industry diversification.
We've committed to give guidance and qualitative comments onannual bookings. Obviously, we are very pleased to announce the increasedguidance from $38 million to $42 million range to $42 million to $44 millionrange. We feel managing the annual bookings number is the most effective way toachieve our long-term goals.
We generally don't break out our headcount by organization,but our overall headcount was 337 compared to 280 at this time last year, as weare increasing staffing in all areas.
Regarding our sales group, which includes sales personnel,solutions, consultant, business development, marketing, we had 29 at the end oflast year, and we're on our plan. We have communicated in the past that we'reincreasing that, and we are on target for our plan for headcount in the salesand marketing area.
Adam Holt - JP Morgan
Terrific. If I couldjust ask one last question on the tax rate, obviously a relatively materialforward-looking increase in the tax rate. Charlie, could you just spend anotherminute walking through the variables there, and whether or not that is a bestguess at this point, or you've got relatively detailed buildup for that number goingout?
That's a greatquestion. I'd say we've got good detail for building up the rate. We've spent afair amount of time on this. Really, going back to why is it rate increasing in2008, it's for the first time in 2007, we've utilized all of our carryforwardswe had on our research and experimentation credits. Also, the relative R&Dspending relative to the company's pre-tax profit is lower now than it was inearlier years. So while we are still generating significant credits, the amountof credit generated relative to the acceleration of our profits is narrowing.So what's happening is that the rates are going up.
At this point, I would say it's our best estimate. We'llcertainly give updated guidance on this when we close the fourth quarter ofthis year, but I think we have done what we can. I think it's good guidance. Wehad previously expected it might have been 23%. Now we're looking at 27% to28%.
Your next question comes from Tom Ernst - Deutsche Bank.
Tom Ernst - Deutsche Bank
Following up on that, I think, as you brought the IPO toinvestors, how is your look-forward then in terms of the build of momentum into2008? I realize you're not giving guidance, but do you feel as strongly knowabout your positioning for growth with your pipeline as you did then, into2008?
I think we would liketo obviously stay away from anything specific until we get to the end of theyear and we get the books closed, we get a chance to give guidance, which willbe early February.
What I will say though, Tom, is that sometimes it'sdifficult, I think, for everyone to fully understand the PROS model. How canyou even be thinking about increases in 2008 or 2007 at the levels that youwere? I think there are some components that are worth emphasizing.
That is that we're not relying entirely on the bookings in2007 to drive revenue in 2008. There are some elements to this. As we'vementioned before, the implementation time is six months to 18 to 24 months foreach contract booked. So contracts signed in 2006 can still be contributing toour revenue in 2008. This is very typical. It's not just the contracts signedin 2007 that are contributing to 2008; it's contracts signed in 2006 as well.
The other is that we do have a number -- not a lot -- ofterm licenses ranging from three to five-year terms. So a term license signedprior to 2007 or a license signed during 2007 would contribute to revenue in2008 and beyond. So that's another element that helps, as far as the momentum behindthe company and its ability to drive revenue in forward years.
Also, maintenance has two components to it. First,maintenance has increased each year by a cost of living adjustment in ourcontracts, so that's a fairly modest increase in maintenance, but nonethelessan increase. Second, maintenance starts when the implementation is completed.Some individuals think of maintenance as just being replaced each year, but forPROS it grows each year. So maintenance in Q4 of 2006 was $4.2 million, and itwas $4.8 million in the current quarter. On an annualized basis, this is anadditional $2.4 million increase in revenue.
We as you have seen in the numbers, maintenance willcontinue to increase. We would expect the fourth quarter maintenance in ‘07 tobe higher than the third quarter. So when you annualize the fourth-quartermaintenance, you're going to see another increase of growth in year-over-yearmaintenance.
With those components, it's not just the bookings in 2007.It's not just the pipeline in 2007. It's all of those components that buildtowards the next year's revenue targets.
Tom, obviously, we are very rigorous. We are very thorough.We anticipate what could happen. We look at every component of our business,and obviously we feel good about the future prospects. So that's why, in myquote, we specifically mentioned that the momentum we are building in thepricing and revenue optimization market increases our confidence and optimismabout our growth prospects for the future.
Tom Ernst - Deutsche Bank
I guess the biggest surprise in this quarter, though, isthat incredible beat on the gross margin side. So I recognize you mentionedthat it's not reoccurring, but can you parse that out for us a little bit?Because with a 400 basis points beat in the gross margin and, in particular,when you look at the license implementation consulting services, my math saysthat was 72%, whereas last year it was 59% on the year in total.
How much of that is driven by improved utilization versusperhaps revenue mix shift to some of the newer products that don't carry asmuch services? What is sustainable and what might be a little lumpy for us?
I think we even put some cautionary words in my script tomake sure we don't get to a point where we start anticipating this kind ofgrowth in gross margins as we go forward. I'd say about maybe half of theimprovement that we've seen in the third quarter was inherent profitability inthe projects themselves, the types of projects the company is doing compared tothe past; which answers your question, is it more the new types of productswe're deploying on the new platform? The other half would be perhaps the levelof just efficiencies we're getting as we continue to deploy products.
As you know, we arefocused on people, process and product and how do we leverage ourselves in thefuture for scalability and increased efficiencies. We are getting someeconomies of scale.
Tom Ernst - Deutsche Bank
What sort of utilization rates do your implementation andconsulting services run at now?
Well, the utilizationrates for our professional services people are very high, because we're in agrowth mode. We are, obviously, hiring people as the revenues continue to grow.But I don't have a specific percentage to give you.
We are moving to more time and materials, and we are alsolooking at some new processes. Obviously, over time, we want to significantlyincrease the efficiency of our professional services implementation staffthrough improved automated tools. As you know, we have a single source codeplatform and configuring that platform, we're building some tools aroundenhanced automation of that configuration. So we think that we're going to beable to increase the efficiency of those people. But without giving you aspecific number, the utilization rate is high.
Your next question comes from Tom Roderick - Thomas WeiselPartners.
Tom Roderick - Thomas Weisel Partners
You gave some metrics earlier around the non-airlinerevenues. When you look at the bookings within the quarter, can you maybe evenjust talk about a couple of anecdotal instances of new deals on themanufacturing and distribution and services side? What sort of trends on thebookings front were you seeing, and any metrics you can offer us around that tosupport not only just the revenue number but also that new sales trend tocontinue to support the growth segment of the business?
Absolutely. As I mentioned earlier, quarter-to-quartermeasurement doesn't always give you a clear picture, or the correct picture, ofthe momentum in the business. As I mentioned earlier, Tom, overall we're seeingan increasing demand in the marketplace for pricing and revenue optimizationsoftware products. We saw this starting in 2005. It continued in 2006, andwe're seeing continued momentum in 2007.
We focused on very specific target industries, because thosewere the industries that had the individual pricing challenges on eachtransaction; the kind of pricing problems that are complex, they are hard, butthe problems that we had solved in the past.
So as we continue to see the CEO awareness, that a-hamoment, we will continue to see growing momentum in the marketplace. That said,we still have a long sales cycle. We have not only good visibility into ourrevenue; we also use a lot of statistical metrics to manage our pipeline. Wethink we have one of the best quantitative and risk-assessed, world-classpipeline management approaches. So we've got great visibility out into ourpipeline and into the future, so we can have the right number of salespeople,sales solutions people, industry domain experts, in order to facilitate thesales cycle and especially at the CEO level, because selling to the CEO is verydifferent than an IT sale.
So we're seeing momentum. We're seeing momentum across ourmarkets, and we feel good about the increased awareness at the CEO level andthe kind of activity we have got going in the marketplace.
Tom Roderick - Thomas Weisel Partners
Charlie, I want to follow up on Adam's question from earlierregarding the tax rate here. Just in terms of a couple of components that aredriving that rate up, you mentioned the higher-than-anticipated profits herewill enable you to utilize those credits earlier, force you to use thosecredits earlier, but also that the R&D spend would be down on a percentage ofrevenue basis.
So in terms of what has changed over the last quarter andthe last few months, which element of that is really driving that tax rate upmore predominantly? Is it just the fact that profits are higher and forcing youto utilize those credits, or do you anticipate that R&D spend will come ina little bit next year to get more leverage out of the model?
It's more the profitsare higher. It's that spread between increasing profits relative to increasingR&D spend. Clearly, the profits in the third quarter of this year wereclearly very good, and the profitability level is such that utilization of allcredit carryforwards occurred in the third quarter, and then you had tore-evaluate the deferred tax assets. As we did the re-evaluation, looking atnext year's R&D projected spending and level of profitability, we think it'sprudent to be providing guidance at approximately 27% to 28%.
Tom Roderick - Thomas Weisel Partners
Just to be clear thatI understand you, as your profits come in better than expected, that is forcingyou to ratchet up that rate? So is it possible that that rate could even higherif profits continue to come in better than expected?
It could, but we'vedone some sensitivity analysis on this, and that's why the 27% to 28%. We'vedone some sensitivity analysis. It could come in higher, but we're comfortablewith the 27% to 28% at this time, and we'll give you an update again at the endof the year. But sitting here today, I don't expect it's going to change.
I did want to comment again on the bookings. Remember, ourbookings tend to be lumpy from one quarter to the next. So the business isdoing well, but we do have lumpy bookings. I just want to remind everyone onthe call that it's difficult for this company to project bookings from onequarter to the next.
We're managing thecompany to an annual bookings number.
Your next question comes from Robert Schwartz - Jefferies.
Robert Schwartz - Jefferies
Just a couple of clarifications. Let me start with what youjust said about managing the annual bookings. How do we think about that $42million then, relative to the kinds of revenue that could be supported? If Iwould look at the bookings that you had in 2006, how would that relate to therevenue we're looking at for this year? Is that a fair comparison?
Yes, I would say it'sprobably a fair comparison, because in any year that we have, of course, thebookings patterns change a bit from quarter to quarter. The size of contractscan very a bit from quarter to quarter, even from year to year. So it isdifficult to get the straight comparability.
I think the way to look at it, Rib, is that as I mentionedbefore, the bookings in 2007 are clearly very important. But it isn't just 2007that drives future revenues; it's 2006 drives future revenues, just as 2006 and2005 is still driving some of 2007. You get the layering effect, because of theimplementation periods being six months to two years. Then of course you getthe layering effect, as I mentioned, of the maintenance; as the maintenancecontinues to build quarter over quarter when you start to annualize that fromyear to year, the maintenance growth can be fairly significant.
So it's the combination of layering in of bookings andlayering in the maintenance that has allowed PROS to grow at a very good ratein 2006 and based upon the guidance we're providing for 2007, at a very goodrate in 2007. 2006 was about 30% revenue growth; midpoint of our guidance isabout 30% revenue growth this year. We've reported, obviously, good numbers for2006 and then reporting good numbers for 2007. So it gives us, directionally,confidence as to where the company is going.
Robert Schwartz - Jefferies
When Tom asked about the sustainability of the gross marginimprovement, you said about half was due to inherent profitability in thoseprojects and half was due to efficiencies. I'm assuming it's the half that's inthe efficiencies that's repeatable? What is it about the projects? They werejust bid well, that the other half isn't repeatable?
I think one elementto it is it's the relative level of implementation services to the totalcontract price. That's going to drive the inherent profitability in a project,so in a quarter or for a couple of quarters, you could have some projects thatinherently have a lower level of implementation services relative to the totalcontract price, the margins are going to be higher.
If you had a quarter that moved on you a bit and you had anumber of projects that had a little more implementation than the priorquarters did, the margins could move down on you. Then we still have theefficiencies that are hopefully continuing to give us the opportunity to drivemargins up.
The reason we're being cautious about this is you can goback and look at the last, say, three years, maybe four years, and you will seequarter-over-quarter gross margin improvements. But this quarter happens to bea margin improvement, as Tom mentioned, that clearly is very good for the company.We're just being cautious as to how we communicate that as we go forward.
It's been a history of profitability through gross marginimprovements for a number of years.
Robert Schwartz - Jefferies
Would thatprofitability be in your control, in some sense, by what kinds of the productsyou're selling, whether you're selling analytics or price optimization? How dowe think about what you have in terms of your ability to influence that partthat's low implementation, high profit, high gross margin?
Yes, I think you'reabsolutely right. Yes, absolutely. If a project had one or two of our modulesthat had less implementation, such as an optimization project typically wouldhave more implementation services, you may see some variations in margins.
Robert Schwartz - Jefferies
So as you get deeperinto customers and sell more optimization, we're likely to see margins go up?Is that a fair summarization?
I'm not so sure that that's fair. I think that the way themodel works is, if someone came in and they signed for all of the products,under our model the margins are going to be consistent across the entirerevenue recognition period. Because, remember, the revenue is recognized basedon the total efforts that are expected over the entire implementation. So ifyou're expecting 12 days of effort and you have one day incurred, you're goingto recognize one-twelfth. But that's products, they are all going to have thesame margin.
If the customer signs for one product and then comes backand signs for two or three more, you could have a little difference in themargins of those two contracts.
Rob, as you know, a substantial amount of our license andimplementation revenue comes from add-on products into our existing customerbase, and we are very pleased with that. One of the things that happens is thatthat add-on product can come in a number of different dimensions.
One, it can be the same the product but deployed in anotherdivision. The classic example is Disney World going to Disneyland,going to Disney Hong Kong. Now obviously, the second deployment has very highgross margins versus a whole new project, and in that particular customer,we've got other projects which are the implementation of a new product in a newdivision.
So it can vary, just like you said; you're absolutely right.It can vary by product. It can vary but what's the implementation, is it acrossthe scope of a new geography or new divisions, or is it a whole new productgoing into a new division?
Robert Schwartz - Jefferies
When you gave a long discussion of your model, you mentionedthat one of the things that people have to keep in mind is the average salesprice. Historically, you've talked about it being about $1.8 million. I'mwondering if you could talk about how stable that has been through the quarterand in recent times? In which verticals you might have seen more strength? Haveyou seen any change in the buying behavior this quarter versus the last timeyou talked to us?
First of all, we communicated that our ASP on a deal was$1.8 million. Even though back in 2005 we expected that to go down, it reallyhasn't. That represents 2.2 products. Also, the momentum we're seeing, if youlook at it over an annualized basis, we are seeing continuing momentum in eachof those industries.
The reason really is that pricing in those industries is sodysfunctional. Consequently, it is easy to find high value business cases, andit's easy to find where you can get a dramatic return on investment. Thatobviously is very compelling to a CEO, regardless of the state of the economyor what other factors. We've had a number of customers, to your point, thathave felt pressure in the marketplace, and even though they felt pressure, theyembraced very eagerly implementing pricing and revenue optimization, becausethey saw it as a way to drive their top line and to create efficiencies intheir pricing that would generate profitability in margins.
So, overall, it feels very good, and we are not seeing adeterioration in our ASP per deal at this time.
Robert Schwartz - Jefferies
A few words on the buying environment?
Activity is good. Theoverall market activity is growing. If you look at the buying environment todayversus six months ago or a year ago or a year-and-a-half ago, there'sdefinitely more activity, more awareness, more people interested. As you know,we have our webinar series, and attendance at our webinars over the last threemonths is much higher than it was, say, six months ago or a year ago.
At this time, I wouldlike to turn the call back over to management for closing remarks. Pleaseproceed.
We're thrilled to bring you these results for the thirdquarter of 2007. Obviously, we feel good about where we are and good about thefuture. As a result of that, we've increased our guidance. We also want to takethis time to thank the investors that have shown confidence in PROS. We've hadan opportunity to meet with a number of you post-IPO, and your feedback andcomments help us to understand how to manage the business and be moreprofessional.
We want to be the very best that we can be. We appreciatevery much your confidence, and we appreciate your feedback. We have had someinvestors visit us here at our Houstonheadquarters, our center for pricing and revenue optimization excellence, andyou are invited to visit us at any time that is convenient for you.
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