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QAD (NASDAQ:QADA)
Q2 2019 Earnings Conference Call
Aug. 22, 2018 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the QAD fiscal 2019 second-quarter financial results call. [Operator instructions] And as a reminder, this conference is being recorded. I'd now like to turn the conference over to Chief Accounting Officer Kara Bellamy.

Please go ahead.

Kara Bellamy -- Chief Accounting Officer

Hello, everybody, and welcome to today's call. Before we begin, I need to ensure that everybody understands our discussion may contain forward-looking statements that are based on certain expectations and analyses. Such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated. QAD undertakes no obligation to revise or update these forward-looking statements to reflect events or circumstances after the date of this call.

For a complete description of these risks and uncertainties, please refer to QAD's 10-K and 10-Q filings with the Securities and Exchange Commission. Please also note that during this call, we will be discussing non-GAAP pre-tax income, which is a non-GAAP financial measure as defined by SEC Regulation G. A reconciliation of this non-GAAP financial measure to the most directly comparable GAAP measure is included in today's press release, which is posted on the company's website. Now I would like to turn the call over to Daniel Lender, QAD's chief financial officer.

Daniel Lender -- Chief Financial Officer

Well, thank you, Kara. Good afternoon, and thank you for joining us to discuss our second-quarter results. Pam Lopker, president, is joining me on the call. Our results for the quarter exceeded our guidance both in revenue and profit.

Strong performance across our subscription, license and services revenue categories contributed to the results. On the cost side, subscription and services margins exceeded expectations. Compared to the same quarter last year, second-quarter revenue increased 11% and subscription revenue grew 29% and now accounts for more than a quarter of our business. Subscription margins grew to 63%, up from 57% a year ago and 62% last quarter.

Higher than expected revenue and slower than planned hiring for our cloud operations resulted in improved margin. We do anticipate increased spending as we add resources in our cloud operations group and as we add capacity to our data centers. We remain on target to achieve and possibly exceed annual subscription margins of 60% for fiscal '19. Our objective is to increase margins by one to two percentage points annually after fiscal '19.

Maintenance and other revenue was $30.6 million, which was down 5% on a performance basis, primarily related to continued customer conversions to the cloud, as well as historical attrition rates. Sequentially, maintenance and other revenue was relatively flat on a performance basis. As cloud conversions increase, maintenance revenue should continue to decline. Recurring revenue, which equals subscription plus maintenance revenue, grew 7% from the prior year and contributed 63% to total revenue for the second quarter compared with 65% a year ago.

The decline as a percent of total revenue was due to the 31% increase in professional services year over year. Professional services revenue was $26 million, up from $19.8 million last year, as new cloud implementations and existing customer upgrade projects continue to generate demand. Services margins remained positive for the quarter at 9%. In addition to our regular ongoing professional services business, we have also been providing some personnel augmentation services to one of our cloud customers, mainly through subcontractors, where margins are minimal.

These services relate to an ongoing multi-site global implementation that has run on time, been very successful so far and is approaching its conclusion. As a result, we expect these services will start to wind down in the third quarter, which will result in lower forecasted services revenue that will be offset by lower subcontractor costs. For the remainder of the year, we continue to expect a small profit in our professional services business. License revenue was $5.6 million versus $6.7 million last year.

We closed seven deals greater than $200,00, with no deals greater than $1 million. We continue to generate license revenue mainly from existing QAD customers as they add new users as they grow in the current strong global manufacturing environment. Currency fluctuations did not have a significant impact on our financial results when compared with the prior year, but did have a negative revenue and positive expense impact to the prior quarter. Total revenue by vertical for the second quarter was automotive at 41%; high tech and industrial, 30%; consumer products and food and beverage, 16%; and life sciences, 13%.

And by geography, total revenue was North America, 47%; EMEA, 32%, Asia-Pacific, 15%; and Latin America, 6%. Our gross margin was $44.1 million compared with $39.3 million for last year's second quarter, and gross margin was 52% of total revenue for both periods. Sales and marketing expense totaled $19.5 million compared with $17.7 million last year and was 23% of total revenue for the fiscal 2019 second quarter and 24% last year. The increase related to additional headcount.

You remember that we made some changes to our sales force that resulted in the reduction of traditional commissioned salespeople and the creation of an inside sales organization, which increased the size of the total group by about 10%. R&D expense was $13.5 million for the 2019 second quarter versus $11.7 million last year. The increase was primarily driven by additional headcount and third-party developers. R&D expense was 16% of total revenue for fiscal 2019 second quarter and 15% last year.

General and administrative expense was $9.4 million or 11% of total revenue compared with $9.2 million or 12% of total revenue last year. This brings total operating expense to $42.4 million or 50% of total revenue for the second quarter compared with $38.7 million or 51% of total revenue last year. Stock compensation expense was $3.4 million for the fiscal 2019 second quarter and $2.6 million last year. The increase was primarily due to the higher stock price.

Operating income was $1.7 million versus $0.5 million last year. GAAP pre-tax income was $2.6 million versus GAAP pre-tax loss of $329,000 for last year's second quarter. Non-GAAP pre-tax income was $5.9 million versus $2.5 million a year ago. GAAP net income totaled $1.1 million or $0.05 per diluted Class A and B share versus GAAP net loss of $1.2 million or $0.06 per Class A and $0.05 per Class B share last year.

Income tax expense was $1.5 million for the fiscal second quarter versus $832,000 for the prior-year quarter, with the increase due to higher profits. For the prior year and last quarter, quarterly tax expense was recorded based on actual tax incurred. Given the higher amount of profit we now expect, tax expense is being calculated based on applying an estimated annual effective tax rate to our results. Next, I'll briefly review our year-to-date results.

For the year-to-date period, total revenue grew 16% to $170.7 million, up from $147.3 million, driven by increases in subscription and services revenue. Subscription revenue grew 34% to $44 million compared to $32.8 million in the year-ago period. Gross margin was 52% of total revenue compared with 51% in the prior six-month period. Subscription margin was 62% for the fiscal '19 period and 54% last year.

Total operating expenses came to $85.7 million versus $76.6 million. As a percent of total revenue, total operating expenses were 50% for the current year-to-date period compared with 52% last year. Our pre-tax income was $5.2 million versus a pre-tax loss of $2.3 million a year ago. Non-GAAP pre-tax income was $10.5 million for the fiscal 2019 year-to-date period compared with $2.7 million last year.

Our GAAP net income was $2.5 million or $0.12 per diluted Class A and $0.11 per diluted Class B share compared with a net loss of $3.7 million or $0.20 per Class A and $0.17 per Class B last year. We ended July with $139.5 million in cash and equivalents compared with $147 million at the end of fiscal 2018. Our accounts receivable was $54.3 million compared with $83.5 million at the end of fiscal '18 and $42.4 million a year ago. Our days sales outstanding using the countback method was 53 days for fiscal 2019 second quarter versus 51 days for the same period last year, and the quality of our receivables remains healthy.

Our short-term deferred revenue balance at July 31 was $91.2 million versus $89.7 million a year ago. And it includes $61.7 million of deferred maintenance versus $63 million, $27.8 million of deferred subscription versus $22.8 million, $1.6 million of deferred professional fees versus $2.7 million and $100,000 of deferred licenses versus $1.2 million. As a reminder, maintenance contracts are billed annually and subscription contracts can be billed either annually or quarterly. Our cash flow from operations was $9.1 million for the first six months of fiscal '19 compared with $7.6 million last year.

I'll finish up our financial review with guidance. For the fiscal 2019 third quarter, we're expecting total revenue of approximately $80 million to $82 million, including approximately $22.9 million to $23.4 million of subscription revenue, our GAAP pre-tax income of approximately breakeven and non-GAAP pre-tax income approximately $2.5 million to $3.7 million. We are raising our full-year guidance to total revenue of approximately $332 million to $336 million, including approximately $91 million to $93 million of subscription revenue; GAAP pre-tax income of approximately $5 million to $7 million; and non-GAAP pre-tax income of approximately $16 million to $19 million. Now I'd like to turn the call over to Pam for a closer look at our cloud and product areas.

Pam?

Pam Lopker -- President

Thanks, Daniel. Q2 was another good cloud quarter. We had 11 new cloud deals, which included six new cloud customers and five conversions. On a regional basis, North America was the strongest and our DynaSys division was a standout.

One of the conversions actually involved multiple customers as it entailed the conversion of all customers from one of our partners in Asia to the cloud as part of our cloud franchise model. I'd like to highlight a conversion of the business unit of an existing industrial customer to the cloud. They were able to show very high value of upgrading by the addition of our QAD demand and supply chain management, automation solutions and transportation management. We beat out SAP on this one and was installed in many of their sites.

And with this, we have now become the division's standard platform going forward. I'd also like to share with you two new cloud customers from our DynaSys division. The first one is a world leader in cableware, one of my favorites. We stood out compared to the competition, FuturMaster and Anaplan, due to our deep functionality and production planning in a very complex environment, our methodology of implementation and our ability to demonstrate rapid ROI.

After a 14-month sales cycle, we secured a five-year deal for the initial site, and our goal will be to deploy the solution globally after this first site is deployed. The other new cloud customer of DynaSys is a global leader in the design and manufacturing of scuba diving and water sports equipment. The competition was Oracle, who they currently use for their ERP, and FuturMaster. After a relatively short five-month sales cycle, we signed a five-year cloud deal and beat out competition due to our ability to go live inside the calendar year, which was supported by several very positive customer references.

Our focus on customer success extends across our product set and continues to be a key differentiator for us. On the product side, we're excited to be releasing Channel Islands into our general availability for QAD cloud ERP customers this September. At this time, we will be moving Channel Islands into limited availability for our on-premise customers. Feedback on Channel Islands has been quite positive.

With recent reviews by [Inaudible] Research, QAD recently received a Frost & Sullivan 2018 Customer Value Leadership Award for the Automotive Industry. The QAD Enterprise Platform was at the center of Frost & Sullivan's decision to give QAD the award. I particularly liked the following statement in their report. "QAD has successfully secured a competitive edge over traditional ERP solutions by eliminating the need for costly, time-consuming customization.

And it has strategically architected the QAD Enterprise Platform to accommodate changes without touching the source code. [Inaudible] Back to you, Daniel.

Daniel Lender -- Chief Financial Officer

Well, thanks a lot, Pam. Although our sales funnel is relatively flat to last year, cloud now comprises 70% versus 60% last year. On a regional basis for the quarter, all regions performed well, similar to previous years. And our full-time employee headcount ended up at about 1,900 employees, up about 4% from last year.

The increase was across all categories except for G&A. Today, we also announced that we entered into a definitive agreement to acquire the assets of one of our partners, PT Iris, which is headquartered in Jakarta, Indonesia. PT Iris has about 40 employees, which are primarily business consultants supporting our customers in Indonesia, and we're excited to have this team work directly for QAD. The Indonesian market is one of the fastest-growing economies in the Asian region with a strong automotive manufacturing presence.

We're not disclosing the specific terms of the transaction, but we do not expect a material impact to fiscal 2019 operating results. The manufacturing economy is still showing strength in the U.S. and on a global basis. And the success that we have had with our customers and the strength of our solution set puts us in a good position to continue executing to our strategy in the second half of the year.

And as usual, we will now take our questions live. Operator, can you please give the instructions for questions? 

Questions and Answers:

Operator

Certainly. [Operator instructions] For our first question, we will go to Brad Reback with Stifel. Please go ahead.

Brad Reback -- Stifel Financial Corp. -- Analyst

Great. Thanks very much. Daniel, as it relates to FX headwinds for the second-half guide, can you give us any color on that?

Daniel Lender -- Chief Financial Officer

Yes. So there's actually some headwinds, Brad. We did experience some headwinds, as I mentioned, from Q1 to Q2. We expect particularly the maintenance line to be mostly affected in the 3% to 4% range.

Brad Reback -- Stifel Financial Corp. -- Analyst

Great, great. So ex -- all things being equal, the guide would have been higher, if not for the FX headwinds, by a few percentage points, especially in maintenance?

Daniel Lender -- Chief Financial Officer

Yes, especially in maintenance, yes. We do also get -- on the cost side, we do get some benefit. So on the operating profit basis, there is a minimal impact.

Brad Reback -- Stifel Financial Corp. -- Analyst

Great. And Pam, maybe you could give us a quick update on how the install is going for the large auto deal that you signed last quarter. Thanks.

Pam Lopker -- President

I think that's -- oh, last quarter or last year. OK, yes, we have -- I'm trying to think of last quarter. Daniel, am I thinking of the one that you just said, that the services revenue would start to decrease because of that? But that was a year ago.

Daniel Lender -- Chief Financial Officer

Yes, yes. So the large [Inaudible], indeed, was signed last year. We did sign another one last quarter, Pam. In fact, you just had a call with them.

Pam Lopker -- President

Oh, thank you. Yes, sorry. Yes, that's going well. They're scheduled to go live here within about, I want to say, six months.

So that seems to be on track. I just did a review with them this morning. Thank you. Thanks, Daniel.

Daniel Lender -- Chief Financial Officer

You're welcome.

Brad Reback -- Stifel Financial Corp. -- Analyst

Great. Thanks very much.

Daniel Lender -- Chief Financial Officer

Thanks, Brad.

Operator

And for our next question, we go to Bhavan Suri with William Blair. Please go ahead.

Bhavan Suri -- William Blair & Company -- Analyst

Hey, guys, thanks for taking my questions. Maybe Pam, I just wanted to touch on one, starting on the Channel Islands piece as it goes to GA. You've always sort of had this idea that the cloud piece would have incremental functionality that would incentivize existing customers to migrate from on-premise to get that functionality in Channel Islands that's available on cloud. And obviously, Channel Islands has that modular-based approach to that migration.

As you think about the customer base, you think about the customer conversations you had and you think about now going GA, when we look at the number of existing-to-new ratio cloud deals per quarter, do you think that mix shifts tremendously into the favor of the existing base? Or do you think it stays relatively where it is over, say, the next year or two years?

Pam Lopker -- President

Well, I do think that the customers, particularly as they upgrade to new releases, and Channel Islands being a great one, look to go to the cloud because they -- instead of having to learn new technologies, new capabilities on an on-premise environment, it makes sense for them to go to the cloud. So I do believe that many of our on-cloud -- on-premise customers are really now seriously looking at moving to the cloud. So I would expect the number of ratios to be leaning more toward on-premise conversions going to the cloud. But at the same time, we still keep picking up new customers.

So it is kind of perplexing. I always thought that we would get proportionately more conversions, but we think to keep on that half and half.

Bhavan Suri -- William Blair & Company -- Analyst

Yes, yes. I guess -- and then a follow-up on that. On the sales motion, I know it's still relatively early. But sort of the shift to inside sales is something a little different for you guys.

Just any early impact or traction or sort of what you might be seeing from that team.

Daniel Lender -- Chief Financial Officer

Yes. So on that end, Bhavan, I think the good thing with any changes in sales, in sales structure, the main thing that we would look for is actually making sure that there's no significant disruption to the sales force. And so far, there hasn't been any, and early indications are that the overall structure of the sales force is being affected. And we're continuing a path of implementing a number of additional techniques and so forth into the overall sales force that we think that, over the long term, should benefit us significantly.

Bhavan Suri -- William Blair & Company -- Analyst

Got it, got it. One last one for me. Daniel, for you maybe. You've sort of explained a little bit about the billings mix and sort of the fact that some of the cloud deals are not annual, and so billings sort of is not a good indicator to look at.

But I was just a little surprised, given sort of the strength in the existing cloud deals, which typically 3x, 2.5, 3, 3.5x in annual recurring revenue, that the subscription revenue growth slowed a bit. So I was just wondering how much of FX impact was there. I might have missed it. Or if that was just something seasonal, and we expect that to pick back up to sort of above that 30%, 35% range.

How should we think about that? I know you've given guidance, but sort of I just was surprised that from 40%, it slowed quite a bit despite the fact we've got sort of these existing customers layering on fairly healthy annual recurring revenue. I know maybe it's going away, but sort of subscription mind, that would be helpful to sort of just walk through the puts and takes. Thank you.

Daniel Lender -- Chief Financial Officer

Yes. So on a year-to-date basis, Bhavan, the growth is 34%. comparing Q2 to Q2 of last year, the growth was 29%. If you go back to last year in Q2, Q2, there was a very significant uptick to that particular quarter, and there were some one-time subscription revenue recognition that affected that one quarter.

So from an OpEx standpoint, you are correct. From quarter to quarter, it does not look as good. And that's why we're really highlighting more what the year-to-date number is because that's more indicative of where the business is at.

Bhavan Suri -- William Blair & Company -- Analyst

Got it. That's helpful. Thanks, guys. Nice job.

Daniel Lender -- Chief Financial Officer

Thanks.

Operator

And our final question comes from Kevin Liu with B. Riley. Please go ahead.

Kevin Liu -- B. Riley FBR, Inc. -- Analyst

Hi, good afternoon. I was just hoping you could touch on, at a high level, if you're seeing any sort of impact on sales cycles just from kind of the ongoing trade negotiations and some of the higher input costs some of the manufacturers might be seeing in their businesses.

Pam Lopker -- President

Well, we're certainly watching that because you can say what the PMI and the change of people buying in anticipation of tariffs. But it has more to do with purchasing, right? So it's like getting those parts in, getting that fill in before the tariff goes into effect, but not necessarily with production. You're actually making and selling things as much because there are more raw materials. But I think it's definitely an interesting time seeing that all going on.

But our customers, for the most part, are all global. So whether they're making something in the U.S. or now they're making something in France or Asia doesn't really make much difference because they're still making stuff and they're still having to add users or buy for users initially. So I do think that with the tariffs, we can have a change in where things are being made but not necessarily how much is being made.

Unless, Daniel, you have another thought on that.

Daniel Lender -- Chief Financial Officer

No, I agree. I agree with all your comments, Pam. Thanks.

Kevin Liu -- B. Riley FBR, Inc. -- Analyst

Appreciate the color. And then just on the subscription gross margin, Daniel, I know you touched on slower pace of hiring so far. But obviously, you guys are ahead of where you want to be at this point. And even if we assume 100 to 200 basis points going forward, you guys are now at levels above that.

So just curious how steep a ramp you expect during the back half in terms of COGS. And beyond this current year, as you roll out Channel Islands and it becomes generally available, what sort of requirements do you have in terms of continuing to ramp up headcount, as well as the associated capacity on that site?

Daniel Lender -- Chief Financial Officer

Yes. So with regards to headcount, as I mentioned in my remarks, we're a little bit behind in terms of where we like to be in terms of hiring. So I do expect that to go up. We're also looking at potentially opening up another data center.

We haven't finalized that decision yet, but that could happen toward the back end of the year. So that would add some additional costs. So as I mentioned, we do think that there's a good chance that we will exceed our goal of the 60%, particularly how strong that number has been in the first half of the year. But I think there's a couple of factors that will have an impact then.

With regards to Channel Islands specifically, that could have a temporary increase in cost as well, but I think it's a little bit early to tell right now exactly what sort of impact we may see on the cost of goods sold line in the cloud on that end.

Kevin Liu -- B. Riley FBR, Inc. -- Analyst

OK. And then just lastly for me as it relates to kind of your partner strategy here. On the one hand, you guys are buying in one of your international distributors. And then also, I know you've been more focused on certifying other parties to help both implement and sell your products.

So I'm curious if you could talk about that dynamic. Are there other distributors you would look to bring in-house? Or why, in this particular instance, did it make sense? And then how is kind of that certification process in terms of ramping up new professionals to support you guys externally, how is that going?

Daniel Lender -- Chief Financial Officer

Yes. So first, let me touch base on the one distributor that we'll be acquiring. I mean, that has to do more with specifically the Indonesian local market, the fact that the automotive sector there is particularly robust and growing. And as you know, we're quite strong in that particular vertical.

So there was just a set of circumstances that led us to making that decision in order to not only support the local customers but really to ensure that we have the right level of support for global customers, putting up production facilities and so forth there. With regards more to the services area, we have been growing our overall capabilities and the number of partners. And in fact, we are -- some more recently signed partners, we can see that they're already being utilized to a greater extent by some of our larger clients. So our strategy is yet to continue to add more capacity to the ecosystem but, at the same time, ensuring that as we add that capacity, that those resources are very well trained.

We have a very robust training program within our services organization. And we actually share our methodologies with regards to implementations because our customers do need us to be able to deliver an implementation on a global basis that is consistent across borders, whether they're being performed by QAD, by one of our partners or a combination.

Kevin Liu -- B. Riley FBR, Inc. -- Analyst

OK. Thanks for taking the questions on next quarter.

Daniel Lender -- Chief Financial Officer

Sure. Thank you very much, Kevin.

Operator

And with our Q&A session completed, we turn back to Daniel Lender.

Daniel Lender -- Chief Financial Officer

Well, thank you very much. Thanks, everybody, for your attendance and your questions. We will update you again in November with our third-quarter results, and goodbye for now. Thanks.

Pam Lopker -- President

Thank you. Bye-bye.

Operator

[Operator signoff]

Duration: 31 minutes

Call Participants:

Kara Bellamy -- Chief Accounting Officer

Daniel Lender -- Chief Financial Officer

Pam Lopker -- President

Brad Reback -- Stifel Financial Corp. -- Analyst

Bhavan Suri -- William Blair & Company -- Analyst

Kevin Liu -- B. Riley FBR, Inc. -- Analyst

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