Earnings Call Transcript - CERT Q3 2023

Operator, Operator

Good afternoon, everyone. Thank you all for participating in today's conference call. On the call from Certara, we have William Feehery, Chief Executive Officer; and John Gallagher, Chief Financial Officer. Earlier today's retire released financial results for the third quarter ended September 30, 2023. A copy of the press release is available on the company's website. Before we begin, I would like to remind you that management will make statements during this call that include forward-looking statements, and actual results may differ materially from those expressed or implied in forward-looking statements. Please refer to Slide 2 in the company materials for additional information, which you can find on the company's Investor Relations website. Management may mention some non-GAAP financial measures in their remarks or responses to questions. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP measures are available in the recent earnings press release on the company's website. Please refer to the reconciliation tables in the company materials for additional information. This conference call contains time-sensitive information and is accurate only as of the live broadcast today November 8, 2023. Certara disclaims any obligation, except as required by law, to update or revise any financial projections or forward-looking statements, whether because of new information, future events or otherwise. And with that, I will turn the call over to William.

William Feehery, CEO

Thank you, David. Good afternoon, everyone. Thank you for joining Certara's Third Quarter 2023 Earnings Call. John and I will start with prepared remarks, and then we will take your questions. In the third quarter, Certara saw sequential improvement and stabilization in overall business trends with bookings growth in both software and services. Total company revenue in the third quarter was $85.6 million, up 1% compared with the same period a year ago. Software revenue in the quarter was $31.3 million and grew 10% versus last year, while services revenue was $54.2 million and declined 4% versus last year. Over the past several months, we have seen a stabilization in activity across the portfolio, though there are some areas of the business that continue to experience more near-term uncertainty than we are accustomed to. We continue to see strong indications of interest for our biosimulation software and services across all tiers of customers. We are executing well on the operational and commercial plan outlined during the second quarter earnings call. Our commercial alignment is beginning to take form with some early enterprise leads already converting to bookings and revenue across the platform. As we make improvements to operating efficiency of the services organization, we continue to identify best practices, which can be implemented more broadly. We are encouraged by initial progress towards our revised goals for the year, and we remain focused on consistent execution heading into the fourth quarter and into 2024. Our third quarter software bookings were $27.2 million, which represented 7% growth versus the third quarter of 2022. Reported software bookings growth was impacted by the timing of certain renewals, with some having booked in the second quarter and some to be booked in the fourth quarter. Software bookings growth was also impacted in our Tier 1 customer segment as a result of industry and macroeconomic headwinds. Despite this, the average software deal size across all customer tiers continued to rise, growing at double digits. We are encouraged by a return to growth for our bookings among smaller biopharma companies. We continue to see broad recognition of the value delivered with biosimulation, instilling us with a lot of confidence in future software performance. Throughout 2023, our software team has continued to make progress on key business and product development initiatives. Since its acquisition in 2021, Pinnacle 21 has become an integral part of Certara's software strategy, and we have developed software features that expand upon Pinnacle 21's initial capabilities. Throughout 2023, we have introduced Pinnacle 21's data exchange offering, which helps customers organize and standardize their data from multiple sources using the CDISC standard. We've also introduced automation for the data management and preparation process involved in SDTM formatting, a key component of data submission. Looking ahead, we believe there will be additional opportunities to expand our Pinnacle 21 offering to complement existing applications. We also continue to make progress in advancing biosimulation with the newest addition to Certara's biosimulation software family. We launched Simcyp biopharmaceutics, a version of Simcyp targeted specifically at scientists working on formulation development. This product continues our strategy of expanding biostimulation by releasing tailored tools aimed at specific scientific problems. Additionally, we continue to invest in developing artificial intelligence capabilities within our existing software platform. Earlier this year, we acquired Vyasa to kick start our AI-enhanced product development efforts. In early October, we announced the availability of Certara AI. Certara AI is a platform designed to deploy client-specific GPs and to answer in-depth questions throughout the drug development process. Certara AI is unique because it is built using its deep learning algorithm, and the data used includes a library of over 60 million life science research documents and the client's proprietary databases, yielding a powerful and proprietary model. One recent advance is our integration of AI in our regulatory writing software, called co-author. Co-Author uses artificial intelligence to aid in drafting regulatory submissions. The product can auto-populate content, summarize studies, craft messaging, and aid the author to deliver the submission. The use of Certara AI and co-author has the potential to drive substantial documentation and writing efficiencies over time. Co-Author, Certara AI, and B360 are all examples of products that are either being enhanced or developed using Vyasa technology relatively quickly. While it is still the early days in AI, we are very excited about the potential that artificial intelligence and machine learning can bring to Certara's products and, in turn, to our customers. Shifting now to our technology-driven services segment, third quarter bookings totaled $57.6 million representing 6% growth compared with the third quarter of 2022. During the third quarter, we observed initial signs of a more stable spending environment among our biopharma customers compared with our second quarter performance. We delivered strong bookings with Tier 3 customers. In addition, services bookings among our Tier 1 customers improved sequentially and grew in the low double digits compared with the prior year period. Following the consolidation of our services business, we are confident that the changes being made will improve coordination in operations and commercial efforts. Certara's regulatory bookings improved sequentially, tracking slightly ahead of our revised internal expectations and grew compared with the same period last year. We remain committed to driving improved performance in our regulatory business over the coming months, and we believe the ongoing integration with the biosimulation services business will help improve the pace of performance. Biosimulation services also performed in line with our expectations, and we saw a pickup in customer activity throughout the quarter. Broader industry demand for our services is steadily improving, and our customers continue to see substantial value in our broad offering of biosimulation services. By bringing Certara's expert consultants on board, our clients gain significant value and efficiency for their projects. As we drive the adoption of biosimulation software, we expect to see increased demand for our services, and we are pleased with the current momentum and trajectory of our business. To close, we are confident in our ability to execute on our plan to drive long-term growth in biosimulation. Certara's platform provides a differentiated offering that continues to be prioritized by customers due to the value we can provide in lowering costs and accelerating timelines to drug project completion. As we look ahead to the fourth quarter and beyond, our focus remains on driving consistent execution to best position ourselves for future growth. I will now turn the call over to John to review our financial results.

John Gallagher, CFO

Thank you, William. Hello, everyone. Total revenue for the three months ended September 30, 2023, was $85.6 million, representing year-over-year growth of 1% on a reported basis and flat on a constant currency basis. Software revenue was $31.3 million in the third quarter, which increased 10% over the prior year period on a reported basis and 9% on a constant currency basis. Growth in the quarter was driven by biosimulation software and Pinnacle 21. Ratable and subscription revenue accounted for 68% of third quarter software revenue. Our quarterly performance is in line with past Q3 seasonality, and we are pleased with the year-to-date performance in software, which is growing in line with expectations. Software bookings were $27.2 million in the third quarter, which increased 7% from the prior year period. Trailing 12-month software bookings were $133.1 million, which increased 13% as compared to the prior year. The software aggregate renewal rate was 86% in the third quarter, and our net retention rate was 107%. We continue to expect that our renewal and retention rates for the full year will be in line with historical company averages. Services revenue was $54.2 million in the third quarter, which decreased 4% versus the prior year period on a reported basis and decreased 5% on a constant currency basis. Services bookings in the third quarter were $57.6 million, which increased 6% from the prior year period. Trailing 12-month services bookings were $270.7 million, which decreased 4% as compared to the prior year. Services bookings have shown signs of improvement as we have progressed through the back half. Total cost of revenue for the third quarter of 2023 was $35.9 million, an increase from $32.8 million in the third quarter of 2022, primarily due to employee costs related to biosimulation services billable headcount growth. Total operating expenses for the third quarter of 2023 were $102.5 million, including a $47 million goodwill impairment expense, an increase from $41 million in the third quarter of 2022. The components of operating expenses are as follows: Sales and marketing expenses were $7.2 million compared to $6.4 million for the third quarter of 2022. This increase is primarily due to employee costs related to expanding the sales and marketing team. R&D expenses were $9 million compared to $6.3 million for the third quarter of 2022. R&D expenses were up primarily due to employee costs for software development related to new product offerings, including the AI products William mentioned earlier. G&A expenses were $27.8 million compared to $17.3 million for the third quarter of 2022. The increase was primarily due to contingent consideration expense on acquisitions. Intangible asset amortization was up to $11.2 million compared to $10.6 million for the third quarter of 2022. Depreciation and amortization expense was $0.4 million, which is flat to the prior year. Continuing down the P&L, interest expense was $5.9 million compared to interest expense of $5.2 million for the third quarter of 2022 due to higher interest expense relating to our floating rate term loan. As a reminder, we have about 78% of our debt fixed at 6.38% and roughly 22% floating at LIBOR plus 350. Miscellaneous income was $5.1 million compared to $2.9 million for the third quarter of 2022. We have a $4.6 million income tax reversal due to an impairment loss compared to a $4.6 million expense for the third quarter of 2022. Net loss for the third quarter of 2023 was $49 million compared to net income of $3.9 million in the third quarter of 2022. Reported adjusted EBITDA was $28.8 million compared to $32.7 million for the third quarter of 2022, a 12% decrease. Adjusted EBITDA margin was 34% in the third quarter of 2023. Reported adjusted net income for the third quarter of 2023 was $17.1 million compared to $16.6 million for the third quarter of 2022. Diluted earnings per share for the third quarter was negative $0.31 compared to $0.02 in the third quarter of 2022. Adjusted diluted earnings per share for the third quarter of 2023 was $0.11 compared to $0.10 in the third quarter last year. Now, moving on to the balance sheet. We ended the quarter with $272.3 million of cash and cash equivalents as of September 30, 2023, and we had $292.2 million of outstanding borrowings on our term loan, and full availability under our revolving credit facility. As we approached the end of the year, we are reiterating our 2023 guidance as follows: We expect total revenue between $345 million and $360 million, representing year-over-year growth of 3% to 7%. We expect adjusted EBITDA in the range of $120 million to $128 million. We expect adjusted EPS in the range of $0.44 to $0.48 per share, fully diluted shares in the range of $159 million to $162 million, and a tax rate in the range of 25% to 30%. We expect 2023 bookings to be down low single digits compared to 2022.

William Feehery, CEO

Thank you, John. To summarize our message today, we have seen a stabilization in customer spending, which is reflected in our third quarter results. Our core growth drivers remain intact, and we are creating new products and services that will further advance the business. The value proposition of biosimulation and Certara's end-to-end products and services remains as compelling as ever. We are confident that Certara is well positioned for growth and profitability over time as a global leader in biosimulation. We will now open the line for questions. Operator, can you open the line?

Operator, Operator

Our first question comes from Jeff Garro with Stephens Inc. Your line is now open.

Jeff Garro, Analyst

First one for me, just wanted to hit on the software side of the business. And maybe you could talk a little bit more about the software renewal rate in the quarter? And I think in the deck, I see a comment on the Tier 1 customers and some issues related to timing. So just curious about that renewal rate and how we should also think about that in the context of the SaaS versus license mix on the software side.

John Gallagher, CFO

Yes, this is John. I'm happy to address that. The overall renewal rate for this quarter is at 86%. This has been influenced by some timing issues, with some renewals moving forward into Q2 and others being pushed into Q4. Historically, we have experienced similar volatility, and it’s common for our aggregate renewal rate to fall in the 80s during one quarter. This year, Q3 is turning out to be that quarter. Looking ahead to Q4, we anticipate the renewal rate will rebound to the 90%.

Jeff Garro, Analyst

Understood. And then one more for me, hit the services side of things. I want to talk about bookings and great to hear the comments on the end market stabilizing and improving through the end of the quarter, and I think positive booking results for the quarter. But I want to ask about that in context of Q4, which is typically a very seasonally strong services bookings quarter for you guys. So I wanted to give you the opportunity to set the right expectations as we think about how services bookings land for Q4 quarter-over-quarter versus Q3, but also year-over-year versus the strong Q4 you had last year?

William Feehery, CEO

Great. Thanks, Jeff. This is Will. As you point out, we did have a nice recovery in our bookings and services in Q3. A lot of that is due to our new reorganization, having a combined sales force and some very good execution by that team, which I think is hopefully a sign of more of that to come. I think we feel pretty good about the deals in the pipeline for Q4 in services, based on customer conversations we've had. So we expect to continue along the guidance pathway that we gave you guys before.

David Windley, Analyst

Good evening. Thanks for taking my question. I think I heard you say, John, that you're still in the guidance commentary, you're still expecting low single-digit decline in year-over-year bookings. I wanted to confirm that. And then in the context of that last quarter, I think you had talked about regulatory services bookings typically having some chunkier amounts that often fall in the fourth quarter, and I think you were not assuming that that would happen this time around. So kind of looking for confirmation around the total, but then also some color around the regulatory services traction.

John Gallagher, CFO

Yes. Sure, David. Yes. So yes, we are confirming that the expectation on the full year is that booking contracts in the low single digits. That's consistent with what we said on the August call. Specifically related to regulatory, we were pleased with the return to growth. We see that as strong execution. So thanks to the team for a job well done there. We had said on the August call that the pipeline for business had visibility. It was really a matter of focus and execution and that we were there to compete. We did that and sharpened our pencil a bit on price, but still within the historical norms and nothing unusual from price. So we're pleased with the momentum that we generated there. Both in regulatory, but also in biosimulation services coming off a weak Q2, we saw a good stabilization and return to growth in Q3, and we were pleased with that.

David Windley, Analyst

I would like to shift to a question about staffing or labor. I'm curious about the current utilization levels of your billable project teams or individuals, especially since bookings have been a bit slow. Are your teams fully utilized at the usual levels? Additionally, what is the current pace of hiring and what is the situation like in the labor market regarding inflation?

John Gallagher, CFO

Utilization in our services business is consistent with our expectations. It varies by project and customer, but overall, it is performing in line with our expectations for the quarter, and we anticipate that will continue in Q4. Regarding hiring, we have slowed down a bit, but that is not linked to the areas generating revenue for us. We have continued to hire in billable roles and will keep doing so, although we have reduced hiring in other non-billable areas of the business.

David Windley, Analyst

Got it. And then maybe I'll just ask that question in a slightly different way. So gross profit margin was pressured just a little bit. It was a little lower than we were looking for, but then it was also lower year-over-year. I guess what I'm digging for is the drivers of that. Was it a utilization issue? Was it a labor rate issue? Was it a mix of business issue? I'm just trying to understand that a little bit better.

John Gallagher, CFO

Right. Yes. Yes. It is the fact that, the revenue that we had in the quarter was lower, as you said, it was 1% growth. We continue to invest in the business. That's why I mentioned, we slowed certain pockets of hiring, but we are continuing to hire, and we don't believe that a restructure of our cost base is the right thing to do. That's a short-term focus. We believe that the opportunity over the long term and the growth prospects remain fully intact. As a result of those investments, you do see the margin. The margin was 34% in the quarter, which, to your point, was a bit off from the typical 35-plus.

William Feehery, CEO

So David, in response to what John mentioned, I would like to add that utilization shifted somewhat during the quarter, especially in regulatory. Coming out of the core bookings in Q2, we were slightly below expectations as we entered the quarter. However, as our bookings began to recover, we saw an uptick. There were also some costs that impacted us early in the quarter related to this situation.

Mike Ryskin, Analyst

Hey, guys. Thanks for taking the question. I want to touch on some of the comments in your prepared remarks and some of the stuff you have there on the slides about early signs of market stabilization, stabilizing activity, some improving trends, et cetera. If we just look at the book-to-bill and the bookings, yes, there was some sequential improvement, but it's coming off a pretty low base. Does one quarter make a trend? Or is it a little too early to call that? Especially as you said that some of these businesses can be a little bit lumpy, timing can be a little bit off. So what gives you confidence that this isn't just some of the usual noise in the business quarter-to-quarter, and it is a more real turnaround?

William Feehery, CEO

Yes, Mike, thank you for the question. It's Will. To be honest, there is quite a bit of uncertainty in the end markets at the moment. We are seeing a reduction in funding activity in the smaller biotech sector, and there are signs of restructuring happening in some of our larger pharmaceutical companies. This likely has some impact on us, although it's difficult to measure. On a positive note, we have a strong position in biosimulation, which continues to grow despite the turmoil. I believe our company is executing better now. We have reorganized our services business and unified our sales force to offer multiple products and services to the same clients. This transition hasn’t yet fully optimized its utilization or efficiency, but we are seeing some positive results from it. Looking ahead, we have thoroughly evaluated our pipeline and our conversations with customers. Therefore, we feel that the trend we see is not just a one-time occurrence this quarter.

Mike Ryskin, Analyst

And then if I could squeeze in a follow-up. I guess to follow up on Dave's question just now on 3Q spending and things like that. Just to put it another way, EBITDA percent came in a little bit lower. EBITDA margin came in a little bit lower than we had worked for. I know that, again, 3Q can often be a well point for the year, and sometimes you have some quarter-to-quarter fluctuations. But just making sure is there anything beyond that to call out, just kind of working through the adjustments, especially with some of those onetime adjustments? I just want to make sure there's nothing unique about EBITDA in the third quarter that's worth calling out?

William Feehery, CEO

Well, yes, let me start this one, and then John may want to chime in. But I would just say that we're very committed and excited about some of the investments we're making in new technologies, and we haven't cut those investments. I referenced artificial intelligence, and we're also launching a lot of new products in QSP and in biosimulation. Despite the turmoil in the market, we believe in the long-term health of this, and we'll continue to invest through it. I think there's a little bit of reflection in our EBITDA margin for that. And John, you might want to chime in too.

John Gallagher, CFO

Yes. Yes, Mike, a couple of things to note. Like you called out, there are some one-timers in here. But if you strip out those and adjust stock comp, keep in mind stock comp returned to the Q1 level in Q3. But if you strip all those away on an adjusted basis, what you find is that Q3 expenses, whether it be sales and marketing, R&D, or G&A on a percentage of sales basis, are consistent with what you saw in Q1 and Q2. The quick answer is there's nothing really to call out there when you strip away the adjustments.

Max Smock, Analyst

Hey, guys. Thanks for taking our question. I wanted to start off just by drilling down on bookings a bit more. I know total bookings in the quarter were in line with your prior commentary about being flat quarter-over-quarter, but software was a little weaker than we expected and services better. I know you reaffirmed your guidance for bookings being down low single digits in '23. But just wondering if the math at all has changed in terms of bookings for each segment this year. Or maybe put another way, how are you thinking about bookings growth for software and services in Q4? Assuming things stay stable from here, what does that mean for bookings next year?

William Feehery, CEO

Right. Yes. So listen, the software bookings in the quarter had some Q2 pull-ahead effect and some push into Q4. Overall, when you look on a year-to-date basis, we've got double-digit software bookings growth. The trailing 12-month bookings for software are 13%. Those are all indicators of strength for the software business. As for next year, obviously, we're not going to give guidance on this call. We will on the next one. The thought is that we've got to focus on executing. You saw that in Q3. We believe the opportunity in biosimulation is firmly intact, and you can see that in our results. The changes we've made will drive some acceleration. We have a backlog that we're working through as well. All of those together, we think spells growth into '24.

Max Smock, Analyst

Okay. That's good to hear. Thanks for the color. I guess, sticking with '24, you mentioned the backlog. Last quarter, you talked about actively assessing your existing backlog of projects, particularly in services. Just wondering if you could share some of the takeaways from this assessment. Any context around how much you have in your services backlog currently? And how much of that backlog do you feel confident will convert to services revenue by the end of 2024?

William Feehery, CEO

Yes. Yes. Max, the good news on that front is our ability to convert that is going to be more meaningful than what you saw in the quarter. We grew services bookings in the quarter, which was great, but the services revenue was a decline year-on-year, and that's predominantly due to what we saw happening in Q2 bookings. We are confident that moving forward, we'll be converting the bookings we've posted and the dynamic that we saw in Q2 and then the reversal of which we saw in Q3 will aid us as we move into next year.

Max Smock, Analyst

To clarify your analysis of the backlog, have you noticed any increase in the cancellation rate compared to your expectations for services? Should we consider that most of the bookings from the past couple of years are still part of that backlog, and it's more a question of when, rather than if, these will convert to revenue at some point?

William Feehery, CEO

Right. Yes. We have not had material cancellations. We maintain from our perspective that it's a slowness and delay, particularly when you look at the Tier 1 customers. We saw some of that come back. We saw average deal cuts. When we looked at the performance in services bookings in the quarter, we saw average deal sizes for Tier 1s and Tier 3s were both growing double digits, which is a positive sign as we look forward. We're not really getting cancellations, but we do continue to see some delays and some slowness in conversion, which is reflected in what you see in the Q3 numbers.

Joe Vruwink, Analyst

Great. Hi, everyone. I think in years past, you've mentioned October is normally a big month for Simcyp renewals and just engaging with the consortium members. I guess that's still through a few questions. One, what did you see for software bookings? You're talking about 4Q, but I'm wondering how much of that is already in hand. And then I have a follow-up question.

William Feehery, CEO

Yes. The momentum we had coming out of Q3 is what we're seeing in October, and that gives us the confidence to keep the guidance on bookings and revenue and the P&L impact where we're at. As we look at October, that's part of what prompted us to stay where we are with the guidance ranges.

Joe Vruwink, Analyst

Great. And then just thinking of the caliber of consortium members. Obviously, these are the organizations typically well into their budget planning for next year. I’m wondering if anything coming up from that planning process makes you feel better or worse entering 2024. Obviously, things can always change. But in terms of any green shoots or early impressions, maybe what your takeaways might be?

William Feehery, CEO

Yes. Thanks a lot for the question. This is Will. We don't break out Simcyp's numbers, but I would say that the demand for Simcyp continues to be quite healthy. We've launched 2 new versions since discovery and then more recently a version called Simcyp Biopharmaceuticals, which are enabling our customers to expand the number of users who can potentially make good use of Simcyp. That's giving us some positive feeling about where that can go as we go into the fourth quarter and then into next year. This does take some time to launch and get out there. The Simcyp consortium consists mostly of bigger companies. They are the most active customers, and we see a continuation of their activity in biosimulation, expecting further growth.

Vikram Purohit, Analyst

Sorry, did you hear my question? So at this point with one quarter left, what are the scenarios that you think could lead to the lower or upper bound of your year-end guidance?

John Gallagher, CFO

Hi, Vikram, yes, it's John. The way to think about that is a number of things would need to be accelerated to be at the lowest end. To be at the very low end of our guidance range, we would need to see a reversal of the momentum that we saw in the services business as well as deceleration in the software business. And to be clear, we don't see that. That's the reason to leave the room in place. But that's what would need to happen to get you to the lower end, and we're not seeing that at the moment. To be at the high end, it's really the opposite of that. We need to see acceleration in each of those fronts versus the momentum we've had coming out of Q3. That's what would push us to the higher end. But to be clear, we reiterated the guidance, with the midpoint there being $352.5 million.

William Feehery, CEO

Right. To John's point, one other thing I can add is that as we've pushed into some of our newer products, particularly in AI, we're finding a lot of customer interest. But to be honest, we don't have past data about how long those deals take to close. There’s some uncertainty as we get into them about just how long does it take to close a deal for something that is pretty new technology that the customers haven't bought before, and we haven't sold before. It's a very exciting field, and I think it's good for the future, but we've left ourselves some room there in recognition that those are harder to predict. All right. Thank you, everybody, for joining us tonight. Just to summarize, we’re pleased that we saw a stabilization in bookings as we entered this quarter. We're experiencing some turmoil in the pharmaceutical market, and I’m quite proud of how the company is executing and adjusting through that. We believe this is relatively short term. We are very confident in biosimulation and where that's going in the long run and the opportunity to continue to expand. We're really excited about what we're doing as we add technologies like artificial intelligence and where that's taking us in the future. We’re continuing to invest in those, expecting that to lead to growth in the future. Looking forward to speaking with all of you next quarter. Thank you very much, and good evening.

Operator, Operator

This concludes the program, and you may now disconnect.