Spok Holdings (SPOK) Q3 2020 Earnings Call Transcript

Spok Holdings (SPOK -0.13%)
Q3 2020 Earnings Call
Oct 29, 2020, 10:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning, and welcome to Spok's 2020 third-quarter investor call. Today's call is being recorded. Online today, we have Vince Kelly, president and chief executive officer; and Mike Wallace, chief operating officer and chief financial officer. At this time, for opening comments, I will turn the call over to Mr.

Wallace. Please go ahead, sir.

Mike Wallace -- Chief Operating Officer and Chief Financial Officer

Good morning. Thank you for joining us for our third-quarter 2020 investor update. Before we discuss our operating results, I want to remind everyone that today's conference call may include forward-looking statements that are subject to risks and uncertainties relating to Spok's future financial and business performance. Such statements may include estimates of revenue, expenses, and income, as well as other predictive statements or plans, which are dependent upon future events or conditions.

These statements represent the company's estimates only on the date of this conference call and are not intended to give any assurance as to actual future results. Spok's actual results could differ materially from those anticipated in these forward-looking statements. Although these statements are based upon assumptions that the company believes to be reasonable, they are subject to risks and uncertainties. Please review the Risk Factors section relating to our operations and the business environment in which we compete contained in our 2019 Form 10-K, our third-quarter 2020 Form 10-Q, which we expect to file later today, and related documents filed with the Securities and Exchange Commission.

Please note that Spok assumes no obligation to update any forward-looking statements from past or present filings and conference calls. With that, I'll turn the call over to Vince.

Vince Kelly -- President and Chief Executive Officer

Thanks, Mike, and good morning, everyone. I hope all of you, your families, and friends remain safe during this challenging time in the midst of this global pandemic. We are very proud of our team and the part we are playing to support our customers, many of whom are on the front line, fighting COVID-19 and saving lives. We are so grateful for the efforts of the doctors, nurses, administrators, and all the first responders, who risk their lives daily.

We believe Spok provides a critical function, which has become even more important in this environment, providing hospitals with a system of action, not just of record, to deliver reliable communication and clinical information, including clinical test results to care teams when and where it matters most to improve patient outcomes. We know that smarter, faster communication is more important now than ever. And as the healthcare industry continues to transform, we remain committed to supporting the hospitals across the nation with reliable communication technology through Spok Go, our new cloud-native platform powered by Amazon Web Services, or AWS. While we're still operating under the impact and uncertainty of the pandemic and many of our customers who are already challenged by constrained operating margins continue to struggle with the challenges presented by COVID-19, our outlook is improving as we saw many positive developments during the quarter.

Third-quarter results were encouraging. We saw strong performance in a number of key operating measures with both sequential and year-over-year improvements. Most importantly, I'm pleased to announce that during the quarter, we closed our first two significant Spok Go deals totaling $812,000 in aggregate contract value. In a few moments, I'll provide more color on our performance that our chief operating officer and chief financial officer, Michael Wallace, will cover our financial performance.

But before I turn it over to Mike, here's an overview of our results for the quarter and the nine months of 2020. During the quarter, we saw significant increases in software operations bookings on both a sequential and year-over-year basis, as well as continued strong trends in our wireless business and record levels for our software revenue backlog. Third-quarter performance was supported by continued strong software maintenance renewals and improved operating expense levels. So far, this year, Spok has generated over $4 million in adjusted EBITDA, growing our cash balances to over $79 million at the end of the third quarter while returning $7.4 million of capital to our stockholders.

In fact, since our formation in 2004, Spok has generated over $1 billion in free cash flow, the majority of which we have returned to our shareholders. Through the first nine months of the year, in the middle of a 100-year pandemic, we have paid our quarterly dividend, grown our cash balances, and enhanced our product offerings through our continued investments in our cloud-native, integrated communication platform, Spok Go. Earlier in the quarter, we were excited to announce that all 20 adult hospitals and all 10 children's hospitals named to the U.S. News & World Report's 2020 to 2021 Best Hospitals Honor Roll use Spok Clinical Communication Solutions to facilitate care collaboration and support exceptional patient care.

For eight consecutive years, Spok has partnered with all of the adult best hospitals. We congratulate our customers to this much deserved and prestigious recognition, and we're proud to support hospitals who are the best at what they do. Partnering with these hospitals as they continue to battle COVID-19 reminds us what we do matters here at Spok. Also, we believe this recognition enhances our credibility and provides momentum.

As earlier this month, we welcomed more than 600 attendees to Connect 20 Virtual, our annual user conference for healthcare professionals. The virtual event provided healthcare clinicians, IT experts, and C-suite executives a chance to learn more about our plans, our new cloud-native solutions, Spok Go, and exchange information with one another about the future of care team communication while sharing insights about how the COVID-19 pandemic has changed how they use health IT. 2020 has been one of the most difficult and unprecedented periods in healthcare. As we look toward the future of healthcare communications, there are many unknowns yet one thing is certain, healthcare has not changed, the importance of care team communication has not changed.

This year, we were pleased to present our annual conference in a virtual format at no cost to our customers as a gesture of gratitude to all the frontline professionals. The two-day event featured speakers from hospitals and health systems who shared lessons from the response to COVID-19 and how to improve care through better communications and tips to improve efficiencies in the contact center. Attendees also saw the newest capabilities of Spok Go. In the past, we've received requests from investors to attend our user conference.

We've wanted to maintain our focus at the conference on our customers. However, we appreciate that the content of the conference may be of interest to our investors. So this year, for our investor update on November 10, Spok will be providing access to selected presentations from our October Connect 20 user conference. Details on how to access the conference presentations will follow shortly.

Now, I'll briefly review some key results. First, third-quarter software bookings exceeded $21 million and were up on both a sequential and year-over-year basis. Third-quarter bookings included $9.4 million in operations bookings, up from $5.8 million in the prior quarter. Our related software backlog at September 30 was a record $51.7 million, up on a sequential basis, about 7%.

Additionally, a sustained revenue renewal rate on software maintenance contracts contributed to our quarterly performance. Similar to our wireless revenue stream, software maintenance revenue is largely a recurring revenue stream that provides the company with a more stable revenue base. Through the first nine months of 2020, approximately 83% of our revenue base is recurring in nature. This includes both wireless revenue and software maintenance revenue.

Second, wireless subscriber and revenue trends continue to exceed our expectations. Spok posted solid results for wireless products and services in the third quarter. The net decline in paging units totaled 1.9% and was down 40 basis points from the prior-year quarter. Additionally, ARPU, or average revenue per unit, was up from the prior quarter.

As a result, quarterly wireless revenue was down 1.2% from the prior quarter, a 20-basis-point improvement from both the prior and year-ago quarters. This is among the lowest wireless revenue erosion in our history. We were pleased to see the improvement in these more stable trends, especially in our top-performing healthcare segment, which comprises nearly 84% of our paging subscriber base. In addition to our financial performance, progress was made in several other areas, including product development, sales strategy, and key strategic partnership agreements.

From a development standpoint, in the third quarter, we were proud to announce that focus earned System and Organizational Controls or SOC 2 Type 2 compliance for both Spok Go and our paging solutions. This designation follows work performed by a big four auditor who confirms that Spok's information security practices, policies, procedures, and operations, meet the SOC 2 Type 2 standards for managing customer data based on three trust service principles: security, availability, and confidentiality. Cybersecurity has become a top priority for executives in all industries, but especially in healthcare. By earning SOC 2 Type 2 compliance for our Spok Go platform, we are now in a position to provide our customers with an additional level of security controls for protecting patient data.

I'm pleased to report that Spok has maintained SOC 2 Type 2 compliance certification on our solutions for the past three years. The SOC 2 compliance certification is the most widely recognized method for sharing independently reviewed information about a service organization's internal controls. The accreditation means that Spok's solutions meet or exceed the levels of security required for service providers storing customer data in the cloud. Finally, during the quarter, we added 10 new logo healthcare software customers to the Spok family.

We also had 23 six-figure deals in the third quarter, nearly double the number of large deals in the previous quarter and consistent with the new sales activity we saw in the third quarter of 2019. One of those six-figure deals was with a large East Coast healthcare system that is also a clinical partner with the area's largest medical school. Customer chose Spok to be their single source of truth for data, on-call, and code messaging. All 30 contact centers within the system will use the Spok's smart console.

The customer will also implement messenger, redundancy, Epic, and HR data feeds and is committed to five years of prepaid maintenance. We are currently engaged with the customer to include Spok Go in the future. And as I mentioned earlier, we were also pleased to announce that Q3 brought us our first two major sales of Spok Go, our cloud-native clinical communication platform. The first is with the nation's largest tribally operated health system.

Customer chose Spok Go because of its user-friendly interface, scalable, cloud-native architecture, and the credibility of Spok's extensive experience in healthcare solutions. This was a collaborative Spok sale that included more than 30 virtual meetings in the midst of the COVID-19 pandemic to cement the relationship and seal the deal. Customer purchased the Spok Go-based platform with plans to add clinical care and clinical diagnostics in 2021 and console integration in 2022. Another Spok Go sale was to a Midwest acute care hospital and regional referral center, drawing patients from throughout the region.

Spok customers since 1993, the hospital currently deploys SmartSuite and messenger. A physician-led initiative for secure messaging reviewed Spok alongside two of our major competitors. Our sales team was able to demonstrate how Spok could be a single strategic communications partner. Further plans include the replacement of a competitor's middleware and badges with the Spok Go clinical care package and radiology, laboratory workflows with the Spok Go clinical diagnostics package.

I'm proud of our team in the work the team accomplished as we continue to bring our new cloud-native and integrated communication platform to market. We're excited as our team will be able to leverage the sales momentum and the excitement created from our user conference. I'll make some additional comments on our business outlook shortly, but first, Mike Wallace, our chief operating officer and CFO, will review the financial highlights for the quarter. Mike?

Mike Wallace -- Chief Operating Officer and Chief Financial Officer

Yes. Thank you, Vince. Let me start by giving you a bit more detail on our financial performance in the third quarter. And as always, I would again encourage you to review our third-quarter 2020 Form 10-Q, which we expect to file later today as it contains far more information about our business operations and financial performance than we will cover on this call.

As Vince noted, our outlook is improving, and we saw many positive developments during the third quarter, especially in comparison to the conditions experienced in the second quarter. Most importantly, however, we were pleased to close our first two significant Spok Go deals totaling $812,000 in aggregate total contract value, or TCV, with annual recurring revenue, or ARR, of $233,000 and an average contract length of approximately three years. Key drivers of our financial performance during the quarter were software bookings of more than $21 million, up almost 39% from the prior quarter and a 5% increase from the prior year and resulting in a 7% increase in the software revenue backlog level from the prior quarter. Also contributing to our third quarter were those portions of our business, which are recurring in nature with software maintenance and wireless revenue.

Sustained levels of software maintenance revenue renewals and stable ARPU and strong performance in gross additions and disconnects impacted units and service in our wireless business, each contributing significantly during the quarter. And lastly, our continuing discipline in the management of operating expenses has also allowed us to absorb the impacts of our planned investments in product research and development for Spok Go, as well as mitigating the negative impacts from the current operating environment. At this time, I want to review the key areas, which drove our third-quarter financial performance. They include, one, those factors impacting revenue; two, selected items, which influenced expenses, especially given the significant mitigation efforts employed during the quarter; and three, a brief review of the balance sheet and cash flow statement.

As usual, if you have any specific questions about these items or any of our quarterly financial results, I will be happy to address them during the Q&A portion of this morning's call. With respect to revenue for the third quarter of 2020, total GAAP revenue was $37.7 million. This compares to $35.7 million in the second quarter of 2020 and $39.5 million in the prior-year period. Through the first nine months of 2020, GAAP revenue totaled $110.7 million.

This compares to revenue of $120.7 million in the first nine months of 2019. On a GAAP basis, third-quarter software revenue of $16.9 million was up from revenue of $14.7 million in the second quarter of 2020 and is approaching prior-year levels. For the first nine months of 2020, software revenue totaled $47.4 million, compared to revenue of $54.2 million in the prior-year period, reflecting the impact of the global pandemic of 2020 on operations bookings and revenue. Also included in software revenue in the third quarter, albeit small, was $24,000 in subscription revenue from our cloud-native Spok Go platform with the initial bookings discussed previously.

Included in this quarter's financial statements and going forward, we will break out subscription-based revenue. This information is contained in the supplemental information table of our press release and can be sourced in our 10-Q. In conjunction with our Spok Go transactions, the company provides minor implementation services by our professional services group, especially when compared to our legacy on-premise business model, and that is included in the respective CPG. These implementation revenues are included in the services line of our detailed revenue table.

Additionally, in 2021, as the total number of our Spok Go transactions increase, we anticipate disclosing those key performance indicators critical to our subscription business, including but not limited to TCV, or total contract value; average contract length; and ARR, or annual recurring revenue. Software revenue performance was driven by a more than 42% increase in third-quarter software operations revenue from the depressed levels seen in the prior quarter. Adding to this was a slight increase in software maintenance revenue. From a wireless revenue perspective and contributing to the year-to-date performance were stable levels of pager unit churn and solid ARPU rates.

As a result, wireless revenue for the first nine months remained strong, declining a record low of 4.9% from the prior-year period. Turning to operating expenses. We continue to maintain our focus on creating efficiencies in our expense base in order to offset some of the planned increases in product research and development and mitigate the impact of the current operating environment, given the impact of the pandemic. During the third quarter of 2020, we reported adjusted operating expenses, which excludes depreciation, amortization, and accretion and adds back capitalized software costs of $35.5 million, up from $34.1 million in the prior quarter and down from $39.8 million in the year-earlier quarter.

The $1.4 million increase in adjusted operating expenses from the prior quarter was driven primarily by an increase of $643,000 in cost of revenue resulting from the previously discussed increase in operations bookings and revenue and a $441,000 increase in sales and marketing expense as we ramped up sales of the Spok Go sales software platform and prepared for our Connect 20 Virtual conference. However, in comparison to the year-ago period, adjusted operating expenses in aggregate declined $4.3 million or nearly 11%, largely driven by a decline in virtually all expense categories as we continue to implement cost-containment measures across the organization to offset the impact to revenue of the current operating environment. For the first nine months of the year, after adding back approximately $8.2 million of capitalized software cost, adjusted research and development expenses totaled $19.9 million. This represents approximately a 3% decline from the same period in 2019, driven primarily from furloughs implemented during 2020.

As stated previously, we believe this overall trend of flattening will continue. And we are now past the initial portion of our investments in research and development for our next-generation software platform, and those expenses are approaching a more steady-state level. Our capital expenses in the third quarter were approximately $934,000, consistent with the prior quarter and down from $1.4 million in the year-ago quarter. For the first nine months of 2020, capital expenses totaled $2.8 million, down from $4.2 million in the year-ago period.

Capital expenses are incurred primarily for the purchase of pagers, network infrastructure to support our wireless customers, as well as the necessary infrastructure to support our software business. We do not expect any significant changes to the level of our capital expense requirements for the balance of 2020. Turning to the balance sheet and other financial items. Through the first nine months of the year, Spok generated approximately $4.3 million of adjusted EBITDA, or earnings before interest, taxes, depreciation, and amortization, plus stock-based compensation and less capitalized software development costs.

This, along with cash on hand and the positive impact of working capital items, was used to fund the quarterly dividends of $7.4 million and the aforementioned capital expenses of $2.8 million. As a result, we ended the quarter with a cash balance of $79.2 million, up approximately $1.9 million from the December 31, 2019 levels. Finally, Spok has been focused on continuing to understand the impact of the pandemic on our business and the potential for another spike, particularly given the impact of COVID-19 on the installation of our premise-based solutions and the rollout of our new cloud-native SaaS-based Spok Go software solution. Due to the fluid nature of the situation, we, like many of our peer public companies, believe that it is most prudent to continue to suspend our practice of providing annual guidance for revenue and expenses at this time.

We look forward to returning to our normal guidance format for 2021 when we report our financial results for the fourth quarter of 2020. With that, I'll turn the call back over to Vince Kelly for some closing comments before we open the call up to your questions. Vince?

Vince Kelly -- President and Chief Executive Officer

Thank you, Mike. Before we open the call up for your questions, I'd like to comment briefly on a couple of items. First, I want to update you on our current capital allocation strategy. Second, I want to review our key goals and business outlook for the remainder of the year.

With respect to our current capital allocation strategy, our overall goal is to achieve sustainable, profitable business growth while maximizing long-term stockholder value. Towards that end, the allocation of capital remains a primary area of focus. Our multifaceted capital allocation strategy includes dividends and share repurchases, as well as key strategic investments that include augmenting our product development and operating platform and infrastructure. Our strategy also includes the potential for acquisitions that are both strategic in nature and that are accretive to earnings.

However, as I mentioned in prior quarters, our main focus is on the development and enhancement of Spok Go versus acquiring additional functionality right now. We believe the cost of acquisitions and the integration of disparate architectures is a much less efficient and ultimately limiting situation than the internal build approach we have taken. As we've outlined in the past, we're in a transition from a wireless company and a seller of premise-based software solutions to a provider of cloud-native, SaaS-based software solutions in the form of Spok Go. We believe that financial flexibility of the long term is important to the success of our strategy.

Spok is laser-focused on selling and enhancing the next generation of our software platform, and we believe that our cloud-native and fully integrated clinical communication platform, Spok Go, will be a game changer in our chosen markets. I'm happy to report that we're on track with our development efforts and rollout plans, and we look forward to taking advantage of what we believe is a large market opportunity for this technology as our customers' financial health returns to full strength. Our capital allocation policy includes our recurring quarterly dividend of $0.125 per share in capital investments in our business. Our board of directors will continue to evaluate our capital allocation strategy, and we'll communicate our plans to you each quarter when we report earnings.

And then finally, with regard to our key business goals and outlook, with respect to the overall health of our customers, the good news is that outpatient procedures were bouncing back to pre-pandemic levels in many markets during the third quarter and early October. However, it's not yet totally clear on the financial damage done in 2020 to our customer base or really what the current big spike in COVID-19 cases might do to the outlook. Barring a return to what the market experienced in the spring, we believe our activities and investments thus far have positioned us to be successful in the fourth quarter and next year. Our business goals are simple, and they include accelerating development of our products and services, maintaining our strong infrastructure, aligning resources, and focusing where most needed to meet customer and market demand, driving software revenue growth while managing wireless revenue declines.

We believe that by focusing on these areas, Spok will be able to generate positive free cash flow through the remainder of 2020. We look forward to laying out our expectations for 2021 when we report our fourth quarter and full-year results in February. At this point, I'll ask the operator to open the call up for your questions. We're going to ask you to limit your initial questions to one and a follow-up, and then we'll circle back as time allows.

Operator?

Questions & Answers:

Operator

Thank you. [Operator instructions] We'll take our first question from Ryan Vardeman with Palogic Capital.

Ryan Vardeman -- Palogic Capital -- Analyst

Hey, guys. Congrats on the Spok Go wins. You referenced a large market opportunity. Early on in the development, you referenced the Gartner report that suggested maybe it was a $3 billion opportunity and then maybe talked about really being a $1 billion subscription opportunity for the solution that we're designing for.

Now that we're further on in the development and have customer data points, can you talk to maybe what the total subscription opportunity for us might be over the next five or 10 years?

Vince Kelly -- President and Chief Executive Officer

Yes. $1 billion, just like we said before, we think it's an enormous market opportunity. Obviously, there's a bit of a hiccup right now with the pandemic, but that hasn't changed our long-term outlook.

Ryan Vardeman -- Palogic Capital -- Analyst

Great. And so then the two Spok Go wins that we have, across how many hospitals are those contracts?

Vince Kelly -- President and Chief Executive Officer

Well, there are two individual healthcare organizations. One of them, in particular, has a lot of physical locations associated with it. The other one, not quite as many. So it's like two out of 7,000 healthcare systems in the United States.

Ryan Vardeman -- Palogic Capital -- Analyst

Great. Thank you very much.

Vince Kelly -- President and Chief Executive Officer

You're welcome.

Operator

Thank you. [Operator instructions] We'll take our next question from Richard Dearnley with Longport.

Richard Dearnley -- Longport Partners LP -- Analyst

Good morning. The wins that you referenced, the new logos, some of which were founded quite large. Well, why would they not go with Spok Go? Or is that a matter of they want to see it in -- they'll be a follower rather than a leader?

Vince Kelly -- President and Chief Executive Officer

Great question. And we have a little bit of both. So I was talking to one of our major customers, U.S. News & World Report's Honor Roll, Adult Hospital, huge research center, academic center, and they are very interested in Spok Go.

It's just that they're saying, hey, we just want to see someone else our size and scale using it first. We don't want to take a flyer. The other big deals that were not Spok Go deals that we sold were deals, for instance, with our contact center solution. So Spok Go is a cloud data platform that is a communications layer, that ultimately, all our service lines will spring off.

So whether it's a nursing solution, whether it's an EB solution, whether it's a critical test result solution and ultimately, whether it's a contact center solution. Those will be service lines that ride on top of a platform that is Spok Go. But right now, the components of that platform that we offer do not include a cloud-based contact center solution. We're still selling our prevalence-based contact center solutions and still selling upgrades to existing customers for their solutions, and so a lot of their larger deals are just customers doing big upgrades to their existing premise-based contact center solutions.

But the good news with that is those upgrades that they're purchasing are also essentially the gateway to migrate up Spok Go when Spok Go is ready because it essentially puts the database and the connectors in place that allow us to once they buy Spok Go, very quickly set them up and move them up into the cloud and onto our platform. So you're going to see -- and this is going to go on throughout. I mean, just to be honest, the next couple of years, you're going to see a hybrid situation. You'll see us picking up some new logo, and you'll see us selling some upgrades and some Spok Go to existing customers and finally transitioning, which continue to happen here in the fourth quarter in October.

So far, we expect that it will continue for the rest of the quarter. And really, frankly, I think really for the next couple of years because a lot of customers will have different budgetary priorities. They'll have different things that they're trying to accomplish or triage some of the early adopters, which is good because we want them. We want those reference customers.

And others will be fast followers, and some will just wait, so that's why we had a kind of blend there.

Richard Dearnley -- Longport Partners LP -- Analyst

Right. Well, you answered one of the follow-ons along the way, so good answer. In wireless, it's logical during COVID and the recovery process that people weren't going to start new things. Is it logical that the wireless churn would pick back up as you go into the first half of '21?

Vince Kelly -- President and Chief Executive Officer

That is a great question. And I don't think it's going to tick up a lot. If it ticks up, it will tick up a little. We have had a situation where almost every year since 2004, our rate of wireless churn subscriber revenue erosion has decreased.

So if you think, if you graft it, it looks like a ski slope and like you're approaching a limit. I mean, we've had the lowest churn in terms -- or erosion in terms of revenue last quarter, I think, in our history. So if it bumped up a little, 20 basis points, 40 basis points, that wouldn't surprise me, but it wouldn't, I think, much change the outcome at all in terms of the kind of glide path that we seem to be on now with respect to trend.

Richard Dearnley -- Longport Partners LP -- Analyst

Right. OK. Thank you very much.

Vince Kelly -- President and Chief Executive Officer

You're very welcome.

Operator

[Operator instructions] I'm showing no questions in queue. I'd like to turn the call back to Vince Kelly.

Vince Kelly -- President and Chief Executive Officer

Thank you very much for joining us this morning. We look forward to speaking with you again after we release our fourth quarter and full-year results in February. And again, I want to remind you our investor update on November 10 and highlighting the presentations from our Connect 20 user conference, I think you'll find this quite interesting and rewarding use of your time. And we'll get the details on how to access those presentations to you shortly through our investor relations portal and our investor relations professional, Al Galgano.

Thank you very much. Stay safe out there and have a great day.

Operator

[Operator signoff]

Duration: 34 minutes

Call participants:

Mike Wallace -- Chief Operating Officer and Chief Financial Officer

Vince Kelly -- President and Chief Executive Officer

Ryan Vardeman -- Palogic Capital -- Analyst

Richard Dearnley -- Longport Partners LP -- Analyst

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