Cerence Inc. (CRNC) Q3 2021 Earnings Call Transcript

Good day. Thank you for standing by and welcome to the Cerence Q3 2021 Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the call over to your host, Rich Yerganian. Please go ahead.

Thank you. Welcome to Cerence's third quarter fiscal 2021 conference call. Before we begin, I would like to remind you that this call may involve certain forward-looking statements. These statements are subject to risks and uncertainties, as described in the press release preceding today's call. Cerence makes no representations to update those statements after the date hereof. In addition, the company may refer to certain non-GAAP measures, key performance indicators, and pro forma financial information during this call. Please refer to today's press release for further details of the definitions, limitations, and uses of those measures and reconciliations of non-GAAP measures to the closest GAAP equivalent. Joining me on today's call are Sanjay Dhawan, President and CEO of Cerence; and Mark Gallenberger, CFO of Cerence. As a reminder, the only authorized spokespeople for the company are Sanjay, Mark, and me. Before handing the call over to Sanjay, I would like to announce several upcoming investor events. They are all virtual events, so the exact timing of our participation is subject to change. The conferences include the Raymond James 2021 Diversified Industrial Conference on August 24, Cowen's Transportation & Mobility Conference on September 9, the RBC Global Industrials Conference on September 10, the Jefferies Software Conference on September 14, and the Evercore Autotech Forum on September 21. Please visit the Events page in the Investors section of the Cerence website for the most up-to-date information on our participation. Now on to the call. Sanjay?

Thank you, Rich. Welcome to everyone on the call and thank you for joining us to discuss our third quarter fiscal 2021 financial results. For our call, I'll first review our strong financial performance in Q3, followed by a review of some notable events that took place during the quarter. Next, I'll update our key performance indicators and then hand the call over to Mark to review the detailed financial results. Once again, we delivered a strong financial performance. This is especially the case when considering the headwinds to our license business due to semiconductor shortage. Our revenue came in at the high end of the range, aided by strong year-over-year growth in our variable license product line, which was up 74% year-over-year. The business model continued to deliver better-than-expected performance with non-GAAP gross margin at 79.1% and adjusted EBITDA at $38.7 million or 40%. The result was non-GAAP EPS of $0.62 and cash flow from operations of $24.1 million. When combining our year-to-date results with our guidance for Q4, our full-year forecast is expected to come in at the high end of the range. Mark will provide details in a few minutes. During Mark's comments, he will also be updating all of you on our midterm 2024 model. We had hoped to hold our second Analyst Day in early September as a live event in New York City but unfortunately the rise in the Delta variant of COVID-19 has led us to delay that event until later in the calendar year. We did feel, however, it was important to update you on the 2024 model given the positive updates to the original model. Much has happened since we first introduced our midterm model, especially regarding new product development and adoption, our decision to enter adjacent markets, and a better understanding of how subscription renewals may play out. We have also been able to make sustainable improvements in some of our assumed gross margins. The result is a midterm model with a significantly higher revenue target and improved margin expectations. You will hear the details shortly, but as a management team, we're very pleased to be able to communicate these updated model assumptions. One of the areas that will help us achieve our midterm target is in new applications and connected services. Some of these applications and connected services we have discussed before such as Cerence Pay, Car Life, Tour Guide and others still to come. What was especially encouraging was the momentum we saw during the third quarter related to bookings for these new products in addition to the more than $30 million in bookings we referenced on our last conference call. This bookings momentum was partly the reasons we were able to increase our revenue expectations for the 2024 target model. We also had several notable events and achievements in this quarter. During the quarter, over 60 different car models from more than 15 different OEMs reached Start-of-Production or SOP. The 60 different car models was a record for the company. SOP usually follows two to three years after a design win and represents a critical milestone because it is at that point when the license and connected services begin to generate revenue for the company. The range of cars hitting SOP in the quarter was also impressive and included high-end luxury cars from such companies as JLR, BMW, and Mercedes, with some of the hottest new cars on the market from OEMs that include Ford, Toyota, GM, Volkswagen, Renault, and Stellantis. All of the major geographic regions were represented, including about a dozen SOPs for cars in China. We announced an agreement with SiriusXM, the leading audio entertainment company in North America, that will provide their customers the ability to use their voice to change the channels. Safety and convenience are why using your voice in the car is important, especially when you have to look at the console when changing a channel. With this technology, it will not only create a safer environment for the driver but also through our AI, the system will learn your favorite channels and suggest others you may like as well. Another important agreement was struck during the quarter with HARMAN. This competitive win will combine Cerence's leading conversational AI technology with HARMAN's Ignite platform. HARMAN, a leading Tier 1 supplier to automakers, will integrate Cerence's AI-powered voice recognition technology into their Ignite platform so they can offer hands-free, secure access to the platform's extensive capabilities, providing an intuitive and powerful experience to their drivers. We also entered into a collaboration with Visteon, another leading Tier 1 supplier to the auto industry. In this case, however, the collaboration will combine Cerence's conversational AI, including global language support, with Visteon's Android-based SmartCore technology platform. The solution has been selected by a leading motorcycle manufacturer and will launch in 2024, powering the 12-inch display that offers connected apps and over-the-air software download capabilities. This is an important collaboration as we seek to expand our presence in the two-wheeler market and is an example of our successful ability to do so. There were two other events worth noting during the quarter: First, we were notified of our addition to the S&P 400 MidCap Index. We were pleased to hear of our inclusion in the index as we took it as recognition of the hard work of the entire Cerence team to consistently deliver strong growth and profitability. We are laser focused on continuing this path of building a company to be the most trusted copilot in a car. I'm also pleased to see that our Chief Information Officer, Bridget Collins, was recognized for all of her fantastic efforts on behalf of Cerence. Bridget was named the 2021, Boston CIO of the Year in the corporate category, chosen by her CIO peers. As I said in the press release announcing our recognition, Bridget has been an integral part of my team from day one and is a perfect example of the level of talent in the sales leadership team. Moving on to our KPIs. As expected, several of the KPIs returned to a more positive trend as the quarter most affected by the reduction in cars produced due to COVID fell out of the 12-month trailing period. Specifically, the percentage of cars shipped with Cerence's technology increased to 53%, and the change in the number of cloud-connected cars shipped turned to a positive 12% from what had been a negative number. Our average billings per car increased a healthy 13% year-over-year. The main contributor to this growth is the increasing percentage of cloud-connected cars. The largest increase in the number of monthly active users is indicative of the automakers bringing to market infotainment systems that are more capable and easier to use than Apple CarPlay or Android Auto. For sure, some automakers are in a better position than others to compete for driver mind share but the momentum is clearly building for growing adoption of a well-implemented and OEM-branded human-machine interface in the contract. Our multifaceted growth strategy to deliver sustainable growth continues to play out. It starts with a strong core of leading conversational AI technology for the car and extends to new applications in adjacent markets. We continue to push the innovation envelope for our customers so that they can offer their customers the safest, most enjoyable experience inside the car, which also represents a seamless transition of their digital life from outside the car to inside the car. You may have heard me say this before, but I think it is worth repeating: I drive the Cerence team to enter with three priorities. As a tech company, we must continue to innovate. Since the spinout into an independent company, I'm very proud of the number of new products and technologies Cerence has brought to market. Second, innovation is only an idea unless you execute and turn that idea into a product that you can deliver to your customer on time and with quality. And third, to focus on cost when designing new products because, ultimately, we are in business to make money for our shareholders. I think our financial performance is a good indication of the emphasis we put on cost efficiency. These are the guiding principles we will continue to rely on as the company continues to grow. The previous slide identified how we have expanded the business by developing new products and entering adjacent markets. Our long-term vision for the company is much larger than that. Our goal is to be the central AI brain of the car, essentially becoming a driver's trusted copilot. We see the next big opportunity is to combine vision with voice. We believe this has application not only in driver monitoring but also on-road and cabin monitoring as well. Certainly, this is an area you will hear more from us in the future. I'd like to now turn the call over to Mark so he can review with you the details of the quarter, our Q4 guidance, and also a positive update to our midterm 2024 model.

Thank you, Sanjay. I'll first review another strong performance for our fiscal Q3 and then I'll provide guidance for our fourth quarter. I'll follow those comments with an update to our 2024 midterm target model. We delivered another strong quarter on both the top and bottom lines. Revenue came in at $96.8 million, which is at the higher end of our guidance of $94 million to $97 million and is a 29% increase from the same period last year. Our key profitability metrics were also very strong and exceeded the high end of our guidance range. The non-GAAP gross margin was 79.1%, mainly driven by favorable product mix. Our non-GAAP operating margin was 37.7%, adjusted EBITDA was $38.7 million or 40% margin, and our non-GAAP earnings per share of $0.62 exceeded the high end of our guidance by $0.05. During the quarter, we generated more than $24 million of cash flow from operations and our balance sheet remains strong with total cash and marketable securities of approximately $157 million. Now let's review a detailed breakdown of our revenue. Our strong revenue growth compared to last year was driven by two factors: first, our total license revenue was up 54% year-over-year. Our variable license revenue was up 74% from the same quarter last year driven by continued recovery in auto production. You may recall that our Q3 from last year represented the trough revenue quarter due to the impact of COVID-19 on auto production shutdowns. We believe our variable license revenue during the quarter was impacted by the semiconductor shortage slowing down auto production. Although we cannot exactly quantify how much the semiconductor shortage impacted our business, our variable license revenue is where you would see the most direct impact from lower auto production. Second, our connected services revenue grew 19% from last year. But more importantly, our new Connected Services revenue, which excludes our legacy business, expanded a strong 46% year-over-year due to a continually growing customer base adopting our new connected service offerings. Our professional service revenue was down 5% year-over-year, simply due to the timing of project completion schedules which affects revenue recognition. Moving on to our guidance for Q4. Our revenue guidance of $97 million to $101 million reflects year-over-year growth of 6% to 11% and takes into consideration the current risks and uncertainties of the semiconductor device shortages that are continuing to impact auto production longer than we had expected. We are closely monitoring the situation and believe we have accounted for the impact in our guidance. Keep in mind that only about one-third of our business is directly impacted by auto production in any given quarter, which shows up in our variable license revenue. We expect to generate between $36 million and $39 million of adjusted EBITDA and between $0.55 to $0.61 per share on a non-GAAP basis. For the fiscal year, we have updated our full-year expectations based on our Q4 guidance. As you can see, we are now forecasting materially higher revenue, profit margins, and EPS estimates versus our original guidance that we communicated to you back in November of last year. Although we did not contemplate the semiconductor shortages in our original guidance, we are still delivering better-than-expected results despite this unexpected event, which reaffirms that the digital transformation of the auto industry is alive and well. We were planning to hold an Analyst Day event in early September in New York City. And during that event, update you on the 2024 midterm target model that we first presented in February of last year or about 18 months ago. We were hoping that international travel restrictions would have been lifted by now but they remain in effect due to the increase of COVID-19 cases resulting from the Delta variant. Because we prefer to hold a live event and have our key executives from around the world participate, we decided to delay the event to later in the fall. We don't have a specific date but we will continue to monitor developments related to the virus and keep you posted. So rather than waiting for that event, we decided to provide you with an update to our mid-term target model today. We categorized our changes in two buckets: growth and profitability. First, I'll cover growth. According to IHS, the forecasted penetration rates have increased for Edge AI and connected AI products and services that are getting designed into automobiles. However, this is being offset by lower auto production IHS forecast post-COVID. We've added new revenue streams to our mid-term model including connected renewals and new service offerings such as Entertainment, Extend, Connect, and Browse. Additionally, since our last Analyst Day, we've announced plans to enter two adjacent markets, two-wheelers and elevators, and these markets are now reflected in our midterm target model. Second, I'll cover profitability. We've updated our margin assumptions based on sustainable improvements that we've made to our business over the past 18 months. First, our connected margin assumption has increased from 65% to 77%, driven by our successful One Cloud architecture project and negotiating more favorable contracts with some of our third-party providers. Secondly, we are seeing good sustainable progress on improving our professional services delivery model and increasing our utilization rates, both of which have enabled us to increase our margin assumption from 10% to 35%. And thirdly, we expect economies of scale in our SG&A functions as our business continues to grow. As you can see, these changes are expected to drive some fairly significant revenue improvements. First, on the top line, we've increased the original target from $600 million to $700 million. This is due to several factors, including a greater contribution from new applications and services, an estimated $65 million in contribution from new adjacent markets, including elevators and two-wheelers, and a stronger contribution from professional services. We have seen initial bookings during this fiscal year for some of our new applications and services, which gives us confidence in being able to achieve these targets. But we expect the revenue contribution from them to be more back-end loaded, meaning they're not going to be linear and they're going to follow more of a non-linear curve. Keep in mind this top line growth takes into account the lower forecasted auto production in 2024 according to IHS, but is offset by increasing penetration of connected cars. So all-in-all, we are pleased to be able to raise our revenue target by $100 million. From a non-GAAP gross margin perspective, we increased it by 100 basis points to 76%. We see sustained margin improvement in our delivery of connected services and professional services more than offsetting the lower margins expected from some of the new mobility markets, which are expected to have an element of hardware in the overall solution. For non-GAAP operating margin, we are now modeling 36% compared to the previous 33% due to gross margin improvements and SG&A economies of scale on higher revenue. All this leads to a significantly higher adjusted EBITDA of $260 million, or $50 million higher than our original model, an incremental $100 million in revenue or a 50% drop-through rate. So, in summary, we had another quarter of excellent financial performance. While we remain cautious in the near term due to the semiconductor shortages impacting the auto industry, we are continuing to benefit from the secular tailwinds caused by the digital transformation of the auto industry. Our long-term prospects remain strong and as demonstrated in our updated target model and our focus on innovation and growth, while at the same time crafting a profitable business model will benefit the company and our shareholders well into the future. This concludes our prepared remarks and we will now take your questions.

And your first question comes from the line of Joseph Spak with RBC Capital Markets.

Thanks so much everyone. I wanted to dive in first a little bit to the updated 2024 forecast. So if I look at the segment that is behold and I guess to volumes in the license segment and I look at what IHS was looking for in early 2020 when you first sort of put that it looks like it's maybe 4% lower global production volumes. So just order of magnitude since you're keeping that flat, are you saying the take rates are sort of making up that call it $10 million to $15 million? Is that the right interpretation?

Yes, that is correct. We are seeing the lower IHS production forecast like you're seeing. But we are seeing updates from IHS, which is showing some increase in penetration rates or what you're calling the take rates. And so I think generally speaking, we're comfortable with those two offsetting and keeping the numbers where they are.

Okay. And then just on the margin component of this. So Connected Services, I know you raised that from 65%. I think you've even hinted before that that could settle in around that mid-70s level. But you're kind of already there. So, I guess I'm curious as to sort of why there is a sort of further upside there? And then the new mobility markets I was just a little bit surprised that that was, I know it's a smaller dollar amount, but I'm surprised it's lower margin because I thought you were just sort of leveraging the tech you're using in the other markets. So maybe you could just explain that a little bit?

Yes. So, I think in terms of the new mobility markets, I'll cover that first. There is an element of hardware which generally is going to be a lower margin component. There will be obviously leveraging of existing technologies. But when you combine it with a hardware component for a total solution, we are factoring in that blended component. And so that's why we think coming out of the gate we'd want to model 45% for those margins. And similar to what we did when we first launched our analyst model, 18 months ago, we try to be somewhat conservative just because we are entering new areas and we don't want to put ourselves out there too aggressively. But if things change over time as this market starts to develop further then we can certainly have some room to potentially increase those margin assumptions.

Sorry, I just wanted to quickly follow up on my understanding of the new mobility markets. What kind of hardware is involved? I thought that referred to the motorcycle segment. Are you providing the entire package with the voice component, or just the voice part?

Sure. I think more of it is on the elevator side where there would be hardware on the elevators.

Yes. So Joe, in the two-wheeler space, there is really no hardware. We're working with the Tier 1s like Visteon, Bosch, and others who provide hardware, the so-called head units. And a lot of our software also runs on the phone of the rider. So there is really no hardware component there. The hardware component that Mark is mentioning is on the elevator side. Because elevators have a long life and a large installed base of elevators shipped with no capability of running Edge AI. There is a piece of hardware that we have built their retrofits in existing elevators with Edge AI capabilities. Our core business model though, just to be very clear, is software as a service in the elevator business as well. Although we were sort of forced to kind of put this piece of hardware out at a slightly lower margin. But really, the product that we are leveraging and shipping is the core AI product that you referenced, which is common across auto and so on.

And sorry Mark, I cut you off on the connected margin.

Yes, the connected margins. When we first introduced the Analyst Day model 18 months ago, we had a 65% margin assumption. We kind of blew through that and we're running now low 70s to high 70s. So we're there. We feel like we can sustain that even into the future. We will have some pressure as the legacy connected revenue declines over time. So that puts a little bit of pressure on the blended margins. But like we've done in the past, we tend to be a little bit conservative with these assumptions. And it's always better to be able to improve them over time. But right now we're comfortable with 77%.

Thanks very much, guys.

Your next question comes from the line of Luke Junk with Beard.

Good morning. Thanks for taking my questions. First, I wanted to ask on the two-wheeler markets. Obviously, you highlighted the relationship with Visteon in that market? And had couple of questions related to that. One, if you could speak to the nature of that relationship a little bit more effectively, does this give you a couple of bites in the Apple, in the market? And then overall do you feel like overall commercial momentum in the two-wheeler market is getting closer to a tipping point here? Obviously, you're now including it in your 2024 model which is encouraging.

Yes. So we're very delighted to have this relationship with Visteon, who's definitely in the ... have a great penetration into the two-wheeler market as well besides auto. We're our model is to be the AI platform of choice, not just for cars but also for two-wheelers and other modes of transportation. And what we are trying to do very systematically is to basically reach out to those other adjacencies as well. Two-wheelers are a very important one because of safety. I'm a rider, a two-wheeler rider, and safety is so important and you can't touch the phone and there are times when you want to communicate with other riders and so on and so forth. So bringing these features out is extremely important, and conversational AI plays a very important role. And so we're working both either directly with the OEMs or also indirectly through the Tier 1 channels across different markets. We're right now engaged in China, India. We are heavily engaged in Japan, which controls about 50% of the two-wheeler market. We are engaged with Tier 1s and OEMs in Europe and also in the United States. But we're definitely very happy to announce this relationship that we put a joint press release out earlier in a few weeks back and we're certainly looking forward to further traction.

That's great color. Thank you for that. Second question I wanted to ask about the 2024 revenue model specifically, the fact that you're now adding connected renewals to the model. And I know you're waiting on that, and it was thought that this would be a possibility down the road. But I'm wondering is there any data that you can share behind that decision? And just in general what's informing your view there specifically on the connected renewals?

Yes. So I think we have one or two data points since our last Analyst Day, where we've had renewals. So that's encouraging to see that our customers are looking to extend those cars beyond their original multiple-year subscription period. I think also what we're seeing is even with some of our new connected subscriptions those are trending to be longer in period. So, that gives us the indication that customers know that there's value in that, and that they're willing to commit for longer upfront periods of time. And so – and then also looking at some of our internal schedules as to when some of the original contract periods are ending, we felt like there should be some upside, but we haven't disclosed exactly what that upside is built into the model. We are now factoring some of that into fiscal year 2024 based upon a couple of data points that we've already seen and the fact that some of our newer contracts are actually extending beyond what some of the previous contracts were.

Great. Thank you both for that color. I'll go ahead and leave it there.

Your next question comes from the line of Mark Delaney with Goldman Sachs.

Yes. Good morning, and thanks very much for taking the questions. I was hoping to start with a question about your expectations for the percentage of vehicles that have Cerence technology and how you expect that to evolve? The number of start-of-production vehicles that you talked about for this most recent quarter, I would think is a good positive indicator as those new programs ramp up in volume and give you guys some good visibility into how many vehicles may have Cerence technology on them going forward? I think it's probably a pretty important input as well into the 2024 model. So maybe talk about how you see that evolving? And if you could also touch on your expectations for the 2024 model about what that penetration rate may look like?

Yeah. So – yeah, penetration rates, I think they're going to continue to grow over time. We looked at some of the IHS data for penetration rates in particular that on the connected side those have grown from 18 months ago. I believe it was around 60% penetration rate for connected cars 18 months ago. Now, it's in the high 60% range. And so we've tried to factor that into our analysis. However, offsetting some of that is the fact that IHS is lowering the total volume forecast for 2024 post-COVID. So when we see the puts and the takes between those two, we've decided to hold that revenue stream flat for the core portion of the business. So that's kind of how we've sort of articulated and built out the model.

Okay. That's helpful. And maybe you could also talk a little bit more on your degree of visibility into the 2024 model. I mean, you've given some helpful commentary already on the margin side, but maybe on the $700 million of revenue on the one hand, right, you're signing contracts that are multiple years in length. And even for cars not in production yet you're probably getting to the point where you're already having one or in pretty advanced discussions for 2024 in terms of launches three years out. So I can see some potential good visibility, but you've also – you have a content per vehicle consideration that's feeding into it, in some of these newer markets. So you talked about having some maybe conservatism on margins. Is that sort of logic holding as well for the revenue side of the equation, or is there more uncertainty on that piece of it? Thanks.

Yes, it’s important to note that the automotive sales cycle is quite lengthy, typically spanning two to three years. This provides us with a solid outlook. For fiscal year 2020, we experienced a very strong bookings year, totaling over $800 million, specifically $835 million, which marked a significant increase from the previous fiscal year. We have already shared updates on the first six months ending in March for this year, which also appears to be another promising year for us. The volume of bookings acts as a leading indicator that gives us increased confidence and visibility into 2024 and beyond. The momentum from these bookings is crucial. Our recent standard operating procedures set a record this past quarter, indicating that over time, these bookings are translating into actual revenue and beginning production. These SOPs serve as evidence that bookings precede production volume ramp-up. Although we recorded an exceptional quarter, the effects of these SOPs are just beginning to materialize, and we will see their benefits in future years as new products and vehicles gain traction. It’s not an instantaneous shift, as it takes time for these processes to scale into full production. By 2024, many of these will likely be at their peak in terms of production capacity.

Thank you.

Your next question is from the line of Colin Langan with Wells Fargo.

Hello. Thank you for taking my question. I would like to ask about the ramp-up of these new markets. How should we approach this in terms of new mobility? Have we seen any progress yet, or should we expect contributions to start next year? Similarly, I assume some SaaS solutions are already available within Connected Services. How quickly are those ramping up? What portion of your targets is already included in the backlog you’ve secured, and how much still needs to be acquired? I apologize for the lengthy question. Additionally, could you provide insights on the two-wheeler market regarding its potential size and how many vehicles might require your services?

Yes. So, Sanjay, you want to start that one or you want me to?

I can certainly start that. We will generate revenue this fiscal year from both the two-wheeler market and Connected Services and apps. Initially, we anticipated revenue in the current calendar year, which would be the first quarter of the next fiscal year, but I am now confident we will achieve revenue in both new mobility markets and new connected apps and services within the current fiscal year. Furthermore, regarding how much of the backlog corresponds to revenue, I don't have that specific breakdown available for your question related to the 2024 model. However, we will refresh our backlog at the end of this year or the start of the next fiscal year. In October or November, during our next conference call, we will update the market on our backlog and provide additional insights. Regardless, we feel confident about our current projections, which is why we included these figures in our latest model update. Was there anything else I missed?

I believe the ramp-up for some of these new products will align with the design cycle of our core products. As I mentioned earlier, this means the revenue growth will not follow a linear pattern as we move toward our fiscal 2024 revenue targets. Regarding how back-end loaded it is, I expect some of these newer products to be more back-end loaded since they will follow a similar design cycle and ramp-up as our core business.

Right, Mark. I think there’s one more thing to mention that I overlooked. Colin, you were asking about the total addressable market, or TAM, for these products. We struggled a bit with this and considered including a TAM analysis in this presentation for your reference. However, the TAM figures we currently have are based on management's data. We are in the process of bringing in a third party to perform an independent TAM analysis without access to our management information. This will help validate and provide a more impartial view of the TAM, rather than just a management perspective. Therefore, we decided not to include that in this release of the target model, but we hope to share the TAM analysis with you in the future.

Got it. And just I guess one quick follow-up. I mean on your 2024 pretty big jump in professional services margins. What is the key drivers of that?

Yes. So it's really twofold: One we're focused on improving the utilization rates of those resources. It is people-driven. And so, that's one component. The other component is to shift the mix of onshore and offshore resources. And so, as we change that mix that's improving some of our overall labor costs.

Okay. Thank you very much for taking my question.

Your next question comes from the line of Raji Gill with Needham & Company.

Yes, thank you for taking my questions and I appreciate the updated fiscal year 2024 target. A couple of questions on that target. So, I'm wondering how you plan to recognize revenue for the new applications and services as well as the new mobility markets? Any clarity there in terms of the revenue recognition?

Yes. Many of those will be based on transactions, so we will recognize revenue as those transactions take place. This will align with that type of revenue model. Some may be based on subscriptions. There will be elements with subscriptions that function similarly to our connected subscriptions, which will follow an amortization schedule over the duration of the subscription period.

Got it. And on the fiscal year 2024 target, so with the new connected number staying basically flat from the original guidance, and likewise, with the Edge business I get it in terms of overall units might be coming down 3%, 4%, 5% based on IHS. But I would think though that the ASPs would be increasing over the course of those years that would offset any kind of unit degradation as well as the attach rates for Cloud Connected increasing. So I'm just a bit surprised that that number would be flat even if there's kind of a small unit correction. So, maybe if you could just kind of clarify that in terms of your thought process of keeping those numbers the same.

Yes. So, I think on the connected piece, we had ASP expansion already factored into the original 2024 target model that we originally put out 18 months ago. And so we're still factoring in those ASP expansions in this model. The other thing to keep in mind is unlike the variable licenses which are recognized in the quarter, there is an amortization schedule. And so because of COVID, there were fewer cars shipped right over the past year and so that's going to have a lingering effect on those amortization schedules. And so you got to keep that in mind as well. However, a lot of that's offset by the fact that the penetration rates or the take rates for connected cars is increasing. And so we kind of looked at all of those factors and took some judgment and said, you know what, I think all in all it's going to be about flat because of all the different changes that are happening.

I see. And for the cash flow from operations, you increased that by $50 million. You talked about paying off some debt. Wondering how you're thinking about the capital structure in light of this new updated target?

Yes, I think the capital structure and our high-level plans are still the same which is the first priority is to keep funding the organic investments, which we believe are fully funded. The next priority is to see if there's other external ways that we can grow and accelerate our strategy and our plans through inorganic investment. If you recall earlier this year, we made a small investment in CerebrumX, a data analytics company, and we would expect to do more of those activities as those opportunities arise. And then the last piece is to pay down the debt. I think those priorities are still the same. We haven't changed those priorities. And so first, grow the business and invest organically, second inorganic. And then if there's any excess cash, accelerate the pay down of the debt. And so whether we had an increase in the EBITDA of $50 million but the underlying priorities are unchanged.

Appreciate it. Thank you.

Your next question comes from the line of Michael Filatov with Berenberg.

Hi, there. Thanks for taking my question. I guess just digging into the Connected Services business, the fiscal year 2024 outlook again. Again, a little surprised it's flat, but I mean maybe you could provide a little more detail as possible around maybe your renewal rate assumption, or what percentage of sort of the revenue base today you expect to be rolling off of the initial contracts by fiscal year 2024? And then maybe just any details around what your ASP assumptions would be on those renewals that would maybe help provide some context?

Yes. I think it's still a little premature to give those level of specifics because we just have very limited data points, unfortunately. And I don't like to extrapolate one or two data points into how we think all these are going to unfold. Each deal is going to be somewhat different and have their own uniqueness, if you will. So, I think it's a bit premature to give those types of specifics. But at a high level, you're thinking about it the right way, right? I mean I think when it comes to renewals, there’s going to be a percentage of cars. It's not going to be 100%. I think in terms of renewal durations, those will probably be still multiple years but probably not as long as the original contract period because those cars are just naturally older now. And so I think those are a couple of influencing factors. And then I think what I'm seeing is good news is the fact that more and more of these cars are getting connected and more users are actually using the technology. And so I think because of that, there are going to be more opportunities for us to engage in these renewals because the end consumer is ultimately the one that's going to be driving the demand for it, right? And so I think as the technology becomes more user-friendly, it's giving us – and our customer an opportunity to extend those cars beyond the original contract period.

Got it. Understood. And then just one other question sort of stepping away from the fiscal year 2024 outlook. One of the notable advantages I think that you guys have talked about before with sort of your competitor, the Google GAS system, right, is that its ability to offer sort of this ecosystem this plug-and-play system with its own services and whatever. So Sanjay maybe you could provide a little more detail around what your strategy is, Cerence's strategy is to build out a sort of a similar ecosystem, whether that Cerence is building it internally or working other parties to sort of help compete against that ecosystem model that Google offers?

So we're trying to be sort of neutral to various different ecosystems, because we're very focused on supporting Google or Amazon or Apple in their ecosystems, the big tech ecosystems that we know of here, or any custom ecosystems that may be coming on board with companies, for example, HARMAN Ignite Ecosystem is one such example that I referenced in my remarks. But again we're not just stopping at that. We're also working closely with the Chinese ecosystems as well. The way we're trying to approach this is we're not trying to build a competing big tech ecosystem. Instead, we're trying to be compatible with the big tech ecosystems, which are out there and also support any custom ones that the OEMs may want to support.

Understood. Thanks a lot.

Your next question comes from the line of David Kelley with Jefferies.

Hi, good morning guys. Just a shorter term and then a longer term question. Maybe starting with the Q4 guide, specifically the sequential sales target I think being flat to modestly higher here. We're all hearing about the ongoing variability in production schedules. And understanding clearly you're less exposed to the cycle and this would primarily be a variable license discussion. But just wondering if you could talk about what you're seeing heading into the fourth quarter and visibility to the top line?

A lot of what we are experiencing is influenced by the semiconductor shortages, which significantly impacts our model. Initially, we thought these shortages would primarily affect the first half of the year. However, they are extending into the second half and may continue into 2022. The auto industry is taking longer than expected to resolve this widespread semiconductor shortage. We are incorporating this information into our guidance for Q4. Reports indicate that auto production may actually decrease quarter-over-quarter during the third calendar quarter, which corresponds to our fiscal Q4. We are using various forecasts, including IHS, while also paying attention to feedback from our customers for short-term insights. This forms the basis of our modeling. As for pro services, they have remained flat in the last two quarters, but we anticipate an increase in the upcoming quarter based on our project completion timelines. This is how we have constructed our model for Q4.

Okay, great. That's really helpful. And maybe sticking with Pro services, the 2024 revenue target fairly meaningful raise there for that business. We tend to view it as an indicator for future business for Cerence or development relationships with OEMs. So we're just hoping maybe if you could give us a bit of color on what's driving that raise? And how you think about professional services opportunity?

Yes. So I can start and Sanjay may want to jump in as well. But I think what we see today is we've had a very good growth in our Pro services since we originally set the target. I think originally when we set the target 18 months ago, $85 million that was on the conservative side, quite frankly. And based upon our performance since then it's been good revenue growth for us. And so we're being, I would say basically less conservative on that front. And then we're also looking to go beyond what we just do traditionally with our Pro services right? We want to leverage these valuable resources, but add more value to our customers in the car and do some more work in the car, but beyond what we have traditionally done too. So we think that's going to help us to grow that top line as well.

Okay. Perfect. Thanks for taking my question.

Your next question comes from the line of Jeffrey Van Rhee with Craig-Hallum.

Great. Thanks for taking the question. Just a couple for me. Maybe start with the bookings. I realize you give the update midyear and in the fiscal. There had been some aspirations that it was reasonable to think you could possibly hit the target or hit the bookings you delivered in '20, even though it was a huge year. You still feel the same? You still feel like that's a reasonable aspiration? And again, while you don't quantitatively comment on it or outline it for the quarter, can you give maybe a little bit of qualitative about the value of bookings in the quarter?

Yes. That aspiration is still there and we're feeling good about it in achieving that aspiration. And we'll come back with details end of Q4.

On the bookings or sort of new business front, I mean, I'd be interested if you took maybe your last major win or last couple of major wins. Anything you'd observe there around sales cycles, bake-offs, who are the finalists, sort of deciding factors as to why you got the win? Maybe just a little real-time color about the competitive environment?

The competitive landscape remains consistent, with niche players like SoundHound, iFlytek, and Symphony participating in the competitive evaluations. In broader architectural discussions, the coexistence with major tech companies continues to be a theme. We've received positive feedback from customers regarding our expanded portfolio, particularly in the cloud segment. We're achieving cloud-only wins against past losses, which is encouraging. Overall, there is a favorable response to our portfolio. Additionally, customers have praised our ability to deliver SOPs and run our PS programs without any issues, which is something I'm very proud of, thanks to our employees and teams in PS and R&D. This results in not only getting products completed and shipped but also builds significant goodwill with our customers. As I shared in our recent Board meeting, we currently have no issues with our programs, and we are committed to meeting OEMs' expectations for both schedule and quality in delivering these projects.

Yeah. That's helpful. Thanks guys. Really impressive execution tough market, so thanks again. Appreciate it.

There are no other questions at this time.

Well, thank you all for joining us on today's call. We look forward to engaging with you at upcoming investor conferences or in any other form. And hopefully, sooner rather than later, we'll be able to meet in person again. Thank you again for joining us this morning and have a great day.

This concludes today's conference call. You may now disconnect.