Audiocodes Ltd Q3 FY2020 Earnings Call

Greetings. Welcome to AudioCodes' Third Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. Please note this conference is being recorded. At this time, I'll turn the conference over to Louie Toma with Hayden IR. Louie, you may begin.

Thank you. Hosting the call today are Shabtai Adlersberg, President and Chief Executive Officer; and Niran Baruch, Vice President of Finance and Chief Financial Officer. Before we begin, I'd like to remind you that the information provided during this call may contain forward-looking statements relating to AudioCodes' business outlook, future economic performance, product introductions, plans and objectives related thereto, and in statements concerning assumptions made or expectations as to any future events, conditions, performance, or other matters are forward-looking statements as the term defined under U.S. Federal Securities Laws. Forward-looking statements are subject to various risks and uncertainties and other factors that could cause actual results to differ materially from those stated in such statements. These risks, uncertainties, and factors include, but are not limited to, the effect of global economic conditions in general and conditions in AudioCodes' industry and target markets in particular, shifts in supply and demand, market acceptance of new products and the demand for existing products, the impact of competitive products and pricing on AudioCodes and its customers' products and markets, the timing of product and technology developments, upgrades, and the ability to manage changes in the market conditions as needed, possible need for additional financing, the ability to satisfy covenants in the company's loan agreements, possible disruptions from acquisitions, the ability of AudioCodes to successfully integrate the products and operations of acquired companies into AudioCodes' business, possible adverse impact of the COVID-19 pandemic on our business and results of operations and other factors detailed in AudioCodes' filings with the U.S. Securities and Exchange Commission. AudioCodes assumes no obligation to update this information. In addition, during the call, AudioCodes will refer to non-GAAP net income and net income per share. AudioCodes has provided a full reconciliation of the non-GAAP net income and net income per share to its net income and net income per share according to GAAP in the press release that is posted on the website. Before I turn the call over to management, I'd like to remind everyone that this call is being recorded. An archived webcast will be made available on the Investor Relations section of the company's website at the conclusion of the call. With that said, I would like to turn the call over to Shabtai. Shabtai, please go ahead.

Thank you, Louie. Good morning and good afternoon, everybody. I would like to welcome all to the third quarter conference call. With me this morning is Niran Baruch, Chief Financial Officer and Vice President of Finance of AudioCodes. Niran will start off by presenting a financial overview of the quarter. I will then review the business highlights and summary for the quarter, and discuss trends and developments in our business and industry. We will then turn it into the Q&A session. Niran?

Thank you, Shabtai, and hello everyone. As usual, on today's call we will be referring to both GAAP and non-GAAP financial results. The earning press release that we issued earlier this morning contains a reconciliation of the supplemental non-GAAP financial information that I will be discussing on this call. Revenues for the third quarter were $56.6 million, an increase of 10% over the $51.4 million reported in the third quarter of last year. Services revenues for the third quarter were $119.6 million, up 19.9% over the year-ago period. Services revenues in the third quarter accounted for 34.6% of total revenues. The amount of deferred revenues, as of September 30, 2020, was $64 million, up from $54.4 million as of September 30, 2019. Revenues by geographical region for the quarter were split, as follows: North America, 40%; EMEA, 38%; Asia-Pacific, 19%; and Central and Latin America, 3%. Our top 15 customers in aggregate represented 56% of revenue in the third quarter, of which 39% are attributed to our eight largest distributors. Gross margin for the quarter was 67.1%, up from 62.9% in the year-ago period. Non-GAAP gross margin for the quarter was 67.4%, compared to 63.2% in the year-ago period. Operating income for the third quarter was $11.2 million, compared to $6 million in the prior year period, an increase of 87%. Non-GAAP quarterly operating income was $13.4 million or 23.7% of revenues compared to operating income of $7.4 million in Q3, 2019, an increase of 80%. Net income for the quarter was $7 million or $0.20 per share, compared to net income of $4.4 million or $0.14 per share in Q3, 2019. On a non-GAAP basis quarterly net income was $13.3 million or $0.38 per share, compared to net income of $7.4 million or $0.24 per share in Q3, 2019. As of end of September 2020, cash, cash equivalents, bank deposits, and marketable securities totaled $176 million. Operating cash flow generated during the quarter was $10.9 million. Day sales outstanding, as of September 30, 2020, were 50 days. On August 5, 2020, we declared a cash dividend of $0.14 per share. The dividend, in aggregate amount of $4.6 million, was paid on September 1, 2020. Now, to provide an update on our guidance, we now expect revenues for 2020 to be in the range of $218 million to $222 million, compared to the previous range of $214 million to $222 million. We anticipate non-GAAP diluted earnings per share to be in the range of $1.31 to $1.35 compared to our previously revised range of $1.18 to $1.24 that we updated following the close of the second quarter 2020. I will now turn the call back over to Shabtai.

Thank you, Niran. We are very pleased to report record financial results for the third quarter of 2020, our best quarter ever. Let me focus first on two key topics relating to our business growth and long-term performance. First is revenue growth. Second is our long-term financial model and the derived profitability. We will then discuss the highlights and major developments in the quarter. Let's start with top line growth. The communication and collaboration market continues to expand. We see increased demand for Microsoft Teams deployments. Entering 2020, UCaaS markets were expected to grow annually about 18%. We have clearly seen higher demand build over the past six months, particularly with the work-from-home trend and related technologies experiencing a strong uptick in adoption. Being well-positioned in the cloud-based collaboration market and aligned with Microsoft Teams, we enjoyed significant growth this quarter. Revenue grew 10% year-over-year. However, if we focus on our growth engines, which together provide over $100 million in revenue this year, we can say that growth exceeded 20% in several key business lines. For instance, our UC-SIP business grew about 20% year-over-year, and revenue related to the Microsoft unified communication and collaboration application also grew close to 20%. On an annual level, revenue in the Microsoft UCaaS space is expected to approach $100 million this year. Revenue from our SBC business line, which will exceed $80 million this year, grew substantially more than 20%, and service revenues grew about 20%, with professional and managed services growing even faster. Now regarding our long-term financial model, we have seen record levels in both gross margin and operating margin, with gross margin at 67.4% and operating margin at 23.7%. This marks the second consecutive quarter where the operating margin has exceeded 20%. Operating expenses were capped at about 43.7%, leading to a 23.7% operating margin and a 24.5% EBITDA margin. Looking towards the long-term model, with increased sales of Software-as-a-Service and lower hardware sales, we expect a long-term gross margin to stabilize in the range of 67% to 70% over the next two to three years, assuming operating expenses remain capped at 46% to 48% to allow for room for expansion and investment. It is becoming evident that we have laid the groundwork for a sustainable operating margin of over 20% in the long term. This is an important milestone in our company's history, supported by strong execution in our current markets and strong operational performance. Moving forward, we are focusing on two significant growth areas: Microsoft Teams and our Voice.AI business. In the third quarter, we saw strong performance in our enterprise operations, which make up about 80% of our business and grew well over 10%. Meanwhile, the service provider area, which represents roughly 20% of our overall revenues, remained quite flat. The only downside in the enterprise space was our IP phone business line, which continues to be affected by the work-from-home trend, resulting in stalled procurements for office supplies such as phones. The roots of our growth and success in the third quarter can be traced back to the changes in work habits caused by the COVID-19 pandemic. There is no doubt that collaboration, work from home, and the hybrid work model have quickly become the new normal. In this environment, high-quality remote communications and efficient collaboration tools are essential for organizations to maintain business continuity and remain competitive. Leading collaboration tools like Microsoft Teams, WebEx, and Zoom are integral to this digital transformation. As we discussed, we have experienced a 10% growth year-to-date, meaning a 10% increase for the first nine months of 2020 compared to the same period last year. On service revenues, we saw a 20% growth over the same quarter last year, with professional and managed services growing over 40%. This area is a key investment focus for AudioCodes as we recognize that end-user companies are increasingly favoring managed services over product purchases. Regarding gross margin, we noted that most of the expansion this quarter is due to higher sales of software products and services compared to other product sales. Typically, hardware-related revenue declined 14% year-over-year, while software sales grew 65% and services grew 12% year-over-year. Our net income has also increased significantly this quarter due to the rise in sales, higher gross margins, and relatively stable operating expenses, growing to $13.25 million compared to $10.5 million last quarter and $7.4 million a year ago, representing a more than 75% increase year-over-year. Our cash flow remains strong, producing $10.9 million from operations as planned for the year. In terms of headcount, we added 2.7% to our full-time employee base year-over-year, alongside a 5% overall increase including outsourced staff, demonstrating our confidence in business expansion. Revenues grew to $64 million from $54.4 million a year ago, reflecting a 17.6% increase over the third quarter of 2019. The UC-SIP business line, a key segment for the company, grew about 20% in the third quarter, with significant year-over-year sales increases in our SBC product line and growth in both our Centralized Network Management software and advanced routing solutions. We anticipate the UC-SIP line will exceed $135 million this year with growth above 20%. The SBC business, crucial for our UCaaS operations, grew over 30%. The only segment that did not perform as expected was the IP phone business line, which continues to decline as on-premises device sales are expected to persist due to changing organizational habits. In the Gateway business, we noted an increase in Q3 revenues compared to earlier in 2020, which were flat year-over-year due to two significant deals in international markets. The Gateway segment comprises about 30% of our Q3 revenues, although we expect a general year-over-year decline of around 15%, primarily due to a 20% drop in product sales, while service revenues remained flat. On our Microsoft Teams operations, previous calls indicated a dramatic growth in collaboration tool usage among enterprises, positioning Microsoft Teams as the market leader at 40%. Recent research shows that a growing number of CIOs are standardizing on Microsoft Teams, with that number rising from 27% two years ago to 51% this year. Year-over-year, our revenue from Teams grew 18.5%, and sequentially, it grew 11.8%. New opportunities in Teams continue to expand significantly, showing a visible increase over the preceding months. We also expect that the voice communications area will gain considerable focus from both Microsoft and Zoom, creating favorable conditions for us. Overall, we saw Teams revenues surpass those from Skype for Business, moving from a near split to 60% Teams and 40% Skype in Q3. On a year-over-year basis, Teams revenue for us grew over 400%, and about 30% sequentially. Regarding the creation of new Microsoft Teams accounts, we noted a continued increase, with over 150% year-over-year growth and a 20% increase compared to the second quarter. In terms of opportunities, we noted that Skype for Business experienced a 40% decline in new opportunities year-over-year, whereas Teams saw more than a 270% increase. Our Teams Direct Route solution has been particularly successful, reporting over 200% growth year-over-year. Additionally, we are heavily investing in managed services, evident from our launch of AudioCodes Live for Microsoft Teams, which has generated significant interest. We have a long-term plan to add additional resources to support the managed services side, with notable recent deals that illustrate our ability to generate substantial business from our Microsoft installed base. Looking ahead, we are updating our revenue guidance for 2020 to be between $218 million and $222 million, and our earnings guidance to a range of $1.31 to $1.35. Thank you, and I will now turn the call over to the Q&A session.

Thank you. We'll now be conducting a question-and-answer session. And our first question today comes from the line of Richard Valera with Needham. Please proceed with your questions.

Thank you, and good morning. Shabtai, a question on the Microsoft business, if I heard you right it was up nearly 20%, I think this quarter, and that last quarter, I think it was up only modestly. You had suggested so clearly an improvement there, and it sounds like the big difference may be that the Skype for Business piece did not decline much this quarter. So just wanted to understand that the conflicting dynamic there. Obviously, Teams I think is doing very, very well. Last quarter the declines in Skype for Business nearly offset it, but do you think we're past the worst of the Skype for Business declines? Do you think you've got a relatively stable base there and that we're now on kind of a positive growth trajectory for the overall Microsoft business going forward?

We all recognize that Teams is becoming the primary choice for new organizations looking to adopt Microsoft collaboration, as it is significantly more advanced. However, there will be a lingering decline, and we've already witnessed this. In the second quarter, Skype for Business experienced a sharp revenue drop, going from about $15 million last year to around $11 million this quarter, compared to an average of $20 million in 2019. This represents a modest decline of about 10% this year, and I believe that we will continue to see a gradual decrease in Skype for Business usage. Some companies that previously adopted Skype for Business will still need to finish their deployments, creating a long tail effect. Additionally, certain organizations, particularly those influenced by defense and regulatory factors, will continue to use Skype for Business. I think we have already seen the worst of the decline in the second quarter, and as mentioned, in the third quarter, we are experiencing a decline in Skype for Business that will not significantly hinder the growth of Teams.

Got it, that's helpful. You mentioned some hardware-related products that faced challenges, specifically IP phones and Gateways. It appears that Gateways performed quite well this quarter compared to recent ones. I'm curious about your thoughts on the sustainability of that business at a stable level. As for IP phones, do you believe they have reached a stable level overall? I know the work-from-home trend significantly impacted them, but do you think they might also be stable moving forward?

On the Gateway side, we currently anticipate a decline of about 15% in 2020 compared to the previous year. It's important to note that the revenue consists of roughly two-thirds from product sales and one-third from services. Typically, service revenues remain stable, and we've seen flat revenues in Gateway service. The decline is primarily on the product side, which is expected to drop around 20% from last year's levels. We believe this decline is linked to the transition of countries to all-IP systems. Some countries have postponed their plans this year due to the COVID-19 situation, as they couldn't send teams for product installations. Conversely, two new countries, the U.K. and Japan, have started to progress in this direction. Overall, I expect a continued decline, especially next year and the following year, with a greater impact on product sales and less on services. However, if the pandemic situation improves in a year, we might see an additional decline of about 10% next year, but we anticipate a long tail effect due to larger countries that have yet to begin the transition. Many countries, particularly in the Asia-Pacific region, will have a demand for Gateways. Regarding IP phones, it seems we've possibly seen the worst already. As of early September, there has been an increase in requests for phones, and we know Microsoft is actively promoting this. Everything is interconnected, and in terms of new vendors, the number of players remains limited. We are well-positioned with a strong new offering on Microsoft Teams, so we expect to see some growth in that area in 2021.

Okay, that makes sense. Thank you, Shabtai.

The next question comes from the line of Greg Burns with Sidoti & Company. Please proceed with your questions.

Good morning. Regarding Teams, it appears that from the conferences you've attended, there is an increased emphasis on voice from the vendors. From an adoption standpoint, where do you currently see the voice adoption or penetration rates? I believe it was at a certain level the last time you provided an update; how is it trending in the market?

Right, so basically the numbers that we have quoted a few months ago were coming from other sources in the market. We've not seen new numbers coming up. So it's tough to say whether that's above 5%, 10%, etc. I mean our business is growing. Our voice business is growing, as I've mentioned, 20% year-over-year. I assume that the general Teams application is growing substantially faster. At this point, I have no such data. We assume however that that's a long tail that's created for us, and therefore we should see a very good market for our voice capabilities.

Okay, can you provide an update on some of the projects or beta implementations related to Voice.AI? What are your revenue expectations for that segment this year, and how is it impacting operating losses, specifically regarding the decremental margin from the Voice.AI investment?

I'm sorry, Greg, I missed your last 10 seconds. Could you please repeat the question?

Yes, I was just looking for an update on Voice.AI.

Okay, right. Yes, we are seeing significant activity in the Voice.AI sector. One of our main focuses is on meetings recap, which allows users to automatically generate decisions, action items, and summaries of meetings, all captured by AI and distributed to project and task management systems. This feature also enables users to access meetings they missed. Microsoft announced this meetings recap application last September, and our Meeting Insights solution specifically targets this area. We aim to integrate it into Teams in the next 60 days. Another focus area is our Voca business. With more people working from home, phone usage has increased dramatically, leading many organizations to handle thousands of calls without being able to allocate enough agents. There is a growing demand for virtual agents to manage these calls. We are investing significantly in this space, as the market for virtual agents and conversational IVR is substantial. Additionally, we have a powerful solution called Voice.AI Gateway that connects through voice, enabling both speaking and listening to voice information, which sets us apart in the market. Overall, last year, we generated over $2 million in revenue and bookings, and this year we anticipate between $3 million and $3.5 million in bookings, representing approximately 50% growth.

Okay, what are the costs associated with that part of the business?

Okay. So, yes, last year I think it cost us about between $3 million and $4 million in operating expenses. This year it will decline by about 20% to 30%. We're very hopeful that actually next year, we will definitely avoid substantially reduced. So, all in all, the trend is positive, and we have lower expenses going forward.

Okay, great. Thank you.

The next question is from the line of Walter Pritchard with Citi. Please proceed with your question.

Hi, thanks. I missed the networking revenue figure. Could you provide that number?

We did not. At this stage, technology accounts for about 4%, while networking makes up around 96%. There hasn't been much change this quarter. Therefore, we believe we will continue reporting the company primarily as a networking entity. That's about it.

Okay, and then on the expenses, just curious there, you gave some helpful color around long-term. How do you think about just especially related to sales and marketing, the levels this quarter? How much that was suppressed by COVID, lots of travel and how you expect that to bounce back? I mean, I don't think anybody knows timing for sure, but how, what sort of color could you give us around how suppressed those expenses were relative to the environment?

Hi, Walter, this is Niran. So, in terms of sales and marketing expenses, same as last quarter, we still have some lower expenses related to travel and also marketing events, but as Shabtai mentioned, this is going to be the new standard going forward, we will not see let's say our travel budget next year will not be the same as it was originally planned for this year. So we definitely will continue to see some saving going forward.

Great, in the last quarter, you mentioned that software made up 35% of the mix. I'm curious about the software revenue for this quarter and how you expect it to change from that 35% mentioned previously.

Yes, so software revenues out of the total is approximately the same as last quarter about 35% or so percent.

Your next question is from the line of Raimo Lenschow with Barclays. Please proceed with your question.

Okay. Thank you. Shabtai, could you talk a little bit about what you're seeing when people go around Teams? So you talked about the new accounts kind of growing really nicely for you, but then also, I assume there's a fair amount of Skype for Business customers updating? Are they increasing their footprint within an account? So is that a broader adoption of teams when they move over? Or is it just a one for one kind of update from Skype to Teams, and I had a follow-up?

I believe we generally observe that the transition from Skype to Teams is driven not only by Teams being a Cloud solution but also because Microsoft continually enhances Teams with new features. Skype for Business is more of a static product without ongoing improvements. Overall, there are two types of accounts: those that are transitioning from Skype for Business, like a large Asian bank that is upgrading to access more features, and new companies seeking advanced collaboration tools, considering Microsoft the optimal choice. These companies may come from various environments, including Cisco and others. Currently, we’re seeing more new accounts being created compared to those migrating from Skype for Business to Teams. So, while there’s a mix, the new accounts represent the majority at this point.

Yes, could you please remind us about your vision regarding gross margins and operating expenses? Specifically, is the improvement in gross margin primarily due to mix effects, or how do you view that?

Yes, there has been ongoing gradual improvement in our gross margin over the years. This is primarily a result of a multi-year process involving declining hardware revenues. We are currently retaining a significant portion of foreign investment, around 90 to 95%. This is one of our main sources. Our software segment, particularly SBC, has become a significant revenue driver, generating over $80 million annually. Previously, this was entirely a hardware-focused business line. In our recent sales review from two weeks ago, it was indicated that a portion of SBC sales is now tied to software, both on-premises and largely on cloud platforms like Azure and AWS. We are transitioning to more Software-as-a-Service offerings. As I mentioned, we are placing greater emphasis on investment in services, which will straightforwardly enhance our gross margin.

Okay, perfect. Thank you. Congratulations, great quarter.

Sure. Thank you, Raimo.

Thank you. Our next question is from the line of Samad Samana with Jefferies. Please proceed with your question.

Hi, good morning. Thank you for taking my questions. To follow up on the operating expense question asked earlier by another analyst, OpEx decreased slightly on a dollar basis compared to the previous quarter and also declined a bit year-over-year. Do you believe that the current OpEx level should remain around this amount, and is it sufficient to support low double-digit overall revenue growth for the next several years? How should we consider the balance between growth, investments, and profitability?

Hi, this is Niran. In the third quarter, we observed a decrease in operating expenses compared to the second quarter, primarily due to summer vacations taken by many employees. Historically, the third quarter tends to be lower than both the second and the first quarter. We anticipate that the fourth quarter will see a slight increase in expenses, but overall, we are in the process of planning for 2021. The savings from COVID-related changes, particularly in travel, are expected to continue. While we will see an increase in operating expenses next quarter, it will not be as significant as we had originally anticipated.

Okay, great. Shabtai, could you address a question regarding Teams? When customers are integrating voice solutions using AudioCodes with Teams, do they usually purchase the calling plan through Microsoft, or do they opt to use their own carrier in that situation? I'm trying to understand which aspects they prefer to leverage within Microsoft's environment compared to AudioCodes and the carriers.

Okay. Thanks, Samad. Actually, this is a good point. In the past, I think we've heard going backwards like 6-12 months, we saw kind of a 50:50 split between Microsoft calling plans and the use of direct route for breakout to the PSTN. We have lately heard about a new trend where basically, Microsoft is lowering its emphasis on calling plan, and basically calling plans are more it looks like going to use more the direct route. So from what we heard, I can quote from another analyst annual report that 85% of cloud voices on Teams likely will utilize third-party direct routing, and Microsoft appears to be less interested in telephony, free calling options. So, we expect to see a very vivid direct route as we see business compared to the past.

Great, and just lastly a quick housekeeping question, can you just maybe give us an idea of what level of the book to maintenance contracts are sitting at, and how that year-over-year growth looks through the third quarter?

So, in terms of support contract booking, we are seeing an increase of about 13 to 15% year-over-year growth.

Okay, great, very helpful, thank you again for taking my questions, and congrats on a solid quarter.

Sure, thank you.

Thank you. At this time, we've come to the end of our question-and-answer session. Now, I'll turn the floor back to Shabtai Adlersberg for closing remarks.

Thank you, Operator, would like to thank everyone who attended our conference call today. With continued good business momentum in our markets and execution in the first nine months of 2020, we believe we are on track to achieve another strong year of growth and expansion of our business. We look forward to your participation in our next quarterly conference call. Thank you very much. Have a nice day. Bye-bye.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.