Earnings Call Transcript - CRNC Q3 2023

Operator, Operator

Good day, and thank you for standing by. Welcome to the Cerence Quarter Three 2023 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 conference over to your speaker today, Rich Yerganian, Senior Vice President of Investor Relations. Please go ahead.

Rich Yerganian, Senior Vice President of Investor Relations

Thank you, Brittany. Welcome to Cerence's third quarter fiscal year 2023 conference call. Before we begin, I would like to remind you that this call may involve certain forward-looking statements. Any statements that are not statements of historical fact, including statements related to our expectations, estimates, assumptions, goals, targets, and plans should also be considered forward-looking statements. Cerence makes no representations to update those statements after today. These statements are subject to risks and uncertainties which may cause actual results to differ materially from such statements as described in our SEC filings, including the Form 8-K with the press release preceding today's call, our Form 10-Q filed on August 8, 2023 and our Form 10-K filed on November 29, 2022. 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. The press release is available in the IR section of our website. Joining me on today's call are Stefan Ortmanns, CEO of Cerence; Tom Beaudoin, CFO of Cerence and Iqbal Arshad, our Chief Technology Officer. As a reminder, the only authorized spokespeople for the company are Stefan, Tom, and me. Before handing the call over to Stefan, I would like to mention that we will be presenting at the Goldman Sachs Communacopia Tech Investor Conference in San Francisco on September 6, and at the Raymond James Virtual Lean, Mean and Green Vehicle Investor Conference on September 18. Now onto the call. Stefan?

Stefan Ortmanns, CEO

Thank you, Rich. Welcome everyone and thank you for joining us to discuss our third quarter results. There were several important developments in the quarter I’d like to highlight. First, we delivered solid results with revenue of approximately $62 million, coming in at the high end of our guidance. In addition, our strong focus on operational excellence contributed to all profitability metrics, performing better than expected, except for GAAP net income, which included a charge associated with our convertible debt financing. Operationally, we delivered on everything we committed to in our last call. I'm extremely pleased with the progress the company has made in the last 12 months creating an organizational structure committed to three key principles. First, continue to lead innovation in AI for the transportation space. Second, delight our customers with on-time and quality products. Third, win strategic accounts that support our long-term growth. At the core of our commitment to innovation are the enhancements we are making to several Cerence products using large language models and generative AI. Iqbal will detail these important product updates in his remarks. At a high level, our deep expertise in AI for automotive and strong OEM relationships put us in a unique and favorable position to partner with our customers, to deliver game-changing applications of these technologies. Bringing us one step closer to our future product vision, the immersive companion. As a result, Cerence remains well positioned to capitalize on the transformative trends within AI, incorporating new inputs into our prototype mobility AI platform as we continuously strive to enhance customer experience and expand product functionality. Our core auto business continues to perform well with our global auto penetration rising to 54%. That means that 54% of total new global live vehicle production includes some level of technology from Cerence. This is the third consecutive quarter of increasing penetration. And this figure is now the highest we have seen in nearly two years. This elevated level of penetration continues to be a straightforward endorsement of Cerence’s superior technology. Tom will comment on the product mix associated with this market expansion in a few minutes. While there are some cross currents creating a level of uncertainty about the macroeconomic environment, we remain quite confident in our visibility and our ability to deliver a strong Q4 and full fiscal year. While semiconductor shortages for the auto industry are becoming less of an issue, the uncertain effect of rising interest rates, and the slowing global economy remains a modus concern on auto demand and production. We are monitoring this closely and have considered this for our Q4 and full-year guidance. Also in the quarter, we successfully restructured our debt through the issuance of new convertible notes, and used the proceeds to pay off the term loan that was at a high variable interest rate and to buy back half of the existing notes at half the coupon rate. The net effect is cash interest savings of approximately $8 million a year by moving a sizable portion of our debt from 2025 maturity to 2028, where we are pleased with the results of the transaction. Overall, we continue to make solid progress across key areas as we advance towards our vision for the future for all aspects of our business, product innovation, target markets, and financial model and performance. We believe in our ability to achieve our long-term objective of double-digit revenue growth with strong EBITDA margins. One of the keys to achieving our long-term objective is winning new business with customers. Securing new business and next-generation platform wins is key to our future success. As many of you know, once designed in, you are the supplier of the technology for the program's life. This means a new contract can generate revenue for many years. I'm happy to say that in Q3, we had several strategic wins, and I'm expecting additional ones in Q4. In our core auto business, we had two strategic wins. The first was with a major Japanese OEM where we displaced a competitor to provide connected services. The second was for our emergency vehicle detection technology for a major Korean car company. We also continue to make progress in the two-wheeler and truck markets. We were excited when an iconic motorcycle brand chose our technology over several other competitors, including niche players and consumer tech. While revenue contribution from the two-wheeler segment is expected to be small this year, four two-wheeler solutions started production in Q3 and should support revenue growth in this segment in FY24 and beyond. Our sales team is laser-focused on finishing the fiscal year strong, and I'm confident we will win key strategic pipeline opportunities to drive our business forward. We continue to be extremely pleased with our continued success in building upon our strong core and capitalizing on adjacent market opportunities. On our Q4 earnings call, Tom will provide you with an update on bookings and their expected contribution to backlog and revenue growth. While it may be repetitive for some of you, I want to again highlight our operational priorities as they are vitally important to our near and long-term success. This means meeting or exceeding our customers’ expectations for our technology, maintaining a strong competitive advantage, continuing to focus on operational excellence, and locking down new business opportunities in front of us, including several wins back opportunities. We believe very strongly in meeting our commitments to our customers, employees, and you, our investors. We are on a strong track to deliver fiscal year results better than we anticipated at the beginning of the fiscal year. With that, I'm excited to have Iqbal Arshad, our Chief Technology Officer, on the call with us today. Since joining the company three plus months ago, Iqbal has had an immediate impact. We are excited about how he and Nils Schanz, Chief Product Officer, are teaming up to execute the future vision and direction of our technology. Iqbal will brief you on how we are leveraging the latest in generative AI and large language models to enhance our product offerings. I'm looking forward to how these advancements can help us deliver a truly immersive companion experience to our customers and I look forward to the role Cerence can play in continuing to unite a wide array of technology in the car while maintaining a uniquely branded experience for our customers and delighting our end users. Iqbal?

Iqbal Arshad, Chief Technology Officer

Thank you, Stefan. With decades of extensive expertise in the automotive industry and a strong background in AI innovation, Cerence is exceptionally positioned to integrate the latest AI advancements into vehicles. We possess unparalleled experience and knowledge in applying generative AI and large language models to transportation, alongside a strategic focus on creating innovative user experiences. As we envision the future of in-car experiences, we are dedicated to solving user challenges by utilizing transformer-based foundational AI models. These models allow us to create intuitive voice and multimodal user interfaces, as well as generative AI applications that enable our customers to offer high-value experiences. These new capabilities seamlessly enhance our existing AI-based product lineup. At the heart of this offering is the next-generation Cerence Assistant, which is powered by generative AI. By implementing large language models in our architecture, we are making substantial progress toward our vision of an engaging companion. The Next Generation Cerence Assistant is designed to provide users with more natural, intuitive, and accurate interactions. The assistant effectively manages complex queries and multi-step tasks in one request. Its deep customizability serves both our automaker customers and end users, adapting to their preferences as it learns. Please allow me to showcase some of Cerence Assistant’s new generative AI-powered features. [Video played] Aimed at being friendly, helpful, and enjoyable, the Next Generation Cerence Assistant adds significant value to drivers' everyday journeys. These features will be accessible to our existing Cerence customers, who will greatly benefit from these new generative AI capabilities. Alongside Cerence Assistant, we are making progress with a generative AI-powered car knowledge product mentioned in our last quarter's earnings call. Cerence car knowledge provides users with real-time contextual answers to all car-related inquiries. We are actively working with customers worldwide to adopt and expand our car knowledge product that utilizes large language models and specific data from the OEM. This is just the beginning. We are enhancing our architecture with finely-tuned LLM based on our curated transportation data and leveraging our industry-leading technologies such as audio AI, automatic speech recognition, neural text-to-speech, biometrics, emotional AI, and in-car communications to shape the future of automotive user experiences. I will now turn it over to Tom to provide a more detailed review of the Q3 results.

Tom Beaudoin, CFO

Thank you, Iqbal. I will review our guidance for Q4 and the full fiscal year in a moment. But first, I want to share more details on our Q3 results. Our Q3 results continue to demonstrate my commitment to consistently deliver on our guidance. Q3 revenue came in just shy of $62 million at $61.6 million at the high end of our guidance. This is due to strength in our core business. As we guided on our last call, we closed a new fixed contract in Q4 originally planned for Q3. Consumption of fixed contracts was higher than expected. I will explain why in a few minutes. As revenue came in at the high end of the range, combined with our focus on operational excellence, we exceeded most of the key profitability metrics we guided for the quarter. Non-GAAP gross margin was 66.5%, non-GAAP operating margin was a positive 0.05%, adjusted EBITDA was $2.8 million, or 4.5% margin and non-GAAP loss per share was $0.04. Except for GAAP net income, which was impacted by the refinancing of our convertible debt, most key financial metrics came in above the high end of our guidance. During the quarter, we had negative cash flow, as expected; cash flow from operations was approximately negative $8.2 million. We expect positive cash flow in Q4 and for the full fiscal year. Our balance sheet remains strong with total cash and marketable securities of approximately $116 million. Here's our breakdown of revenue for the quarter: variable license revenue dropped 16% from the same quarter last year, and down slightly quarter-over-quarter due to a higher than expected level of fixed contract consumption. As you will see in a few moments, our penetration of global auto production rose to 54% as we continue to maintain a strong position in the market. The higher level of penetration is partially due to single component solutions in emerging markets, which yield lower revenue per car. We view this as a strategic market expansion opportunity and a potential launching point for gaining further business and eventual higher TTE use with OEMs in emerging markets. New connected services revenue was up 3% from the same quarter last year, while down 3% from the last quarter. You may recall last quarter; we had a true-up of approximately $700,000 from a customer. Adjusting for the one-time true-up, new connected revenue was up quarter-over-quarter. We expect our new connected services to continue to ramp up in FY24 as several key programs that have been delayed by customers go into production. Finally, and as expected, our professional services revenue was down 24% year-over-year and down 8% quarter-over-quarter. As we have stated previously, professional services will vary based on the progress or completion of customer projects. We do not project professional services as a revenue growth driver for the company, but instead as an enabler for future license and connected revenue. Additionally, our newer products and solutions include improved implementation and integration features, which lowers the requirement for professional services. Moving on to the details in our license business. Overall, the license business remains strong and is indicating improvement from the issues that have plagued auto production over the last few years. While the semiconductor shortage seems to be receding, the macro economy and especially higher interest rates have the potential to slow demand and production growth. This and other factors have led IHS to reduce their calendar year production growth to 1%. Pro Forma royalties were up 7% year-over-year and 6% quarter-over-quarter due to the increased auto production and penetration of our technology. Part of the growth in pro forma royalties in the quarter was due to a one-time true-up with a customer that had under-reported royalties of approximately $1 million. Most of this upside revenue was reported in consumption as this customer was operating under a minimum commitment deal. As a result, you can see higher than expected consumption in the quarter. Our Q3 pro forma royalties represented the highest amount in over two years, even when adjusting for the true-up. As we discussed in the call last quarter, we pushed out an expected fixed contract from Q3 to Q4. As a result, we did no fixed contracts in Q3. Since the quarter closed, we have signed the expected fixed contract and we will be staying within our commitment of $40 million for the full year. As you may recall, we have previously stated we model prepay fixed contracts based on an assumed six-quarter consumption period. We have also noted the Q1 fixed contracts that we signed had an expected consumption over eight quarters, leading to lower consumption in FY23 versus our model and extending consumption through FY24. The fixed contract we signed in Q4 has an expected consumption period of four quarters shorter than our model. The net effect of the prepaid contracts we signed in FY23 will yield lower FY23 consumption versus our model and estimated higher consumption of approximately $10 million in FY24. We are providing you as an additional data point this quarter regarding fixed contracts. We expect the inventory balance of fixed contracts at the end of fiscal 2023 to be approximately $98 million, down from approximately $125 million at the end of fiscal 2022. We currently estimate the balance of fixed contracts to be approximately $70 million at the end of FY24 and approximately $57 million in FY25. The balance at the end of each year assumes the addition of $40 million of new fixed contracts, less expected six-quarter consumption. The majority of our key performance indicators continue to indicate strength in the business. Our penetration of global auto production for the trailing 12 months increased to 54% from 53% last quarter. This means over half of global auto production includes some level of Cerence technology. 12.2 million cars with Cerence technology were shipped in the quarter. This is up 25% year-over-year and reflects the improving production environment and our continuing strong competitive position. Cars produced that use our connected services increased 50% year-over-year, reflecting the trend of more and more cars being connected and the growth of our ability to successfully provide our customers with innovative cloud-based solutions. We also saw a large increase in monthly active users, 29% year-over-year, indicating increased popularity among consumers of our technology. Billings per car KPI declined 6%, including a negative FX impact of 200 basis points. The decline is primarily due to product mix. Some of the new business contributing to growing licenses and increased penetration is coming from emerging markets, where OEMs initially are adopting components of our full software stack. These are important wins that are driving penetration and the opportunity for these customers to drive higher revenue per car over time as they adopt additional components of our technology. The other factor, which we mentioned on our last conference call, are macroeconomic and OEM driven delays in the start of production, a higher price per car next generation platforms. We see a positive trend in this KPI and expect it to trend higher over the next few quarters. Now turning to revenue guidance for Q4 and fiscal year, as I mentioned earlier, as expected, we closed the Q4 fixed contract of approximately $13 million. For Q4, we are guiding revenue from $72 million to $76 million. The tight range is due to knowledge of the fixed contract already closed and strong visibility to our other revenue sources. With our strong first three quarter results, and strong visibility to Q4, we are providing a narrow range for our full fiscal year guidance of $286 million to $290 million, raising the midpoint of our full year guidance to $288 million. You can see on this slide, the revenue guidance and its associated financial metrics. Overall, the business continues to perform. As we outlined at the beginning of the fiscal year, we remain focused on innovation, operational excellence, and strong bookings in the second half to achieve our long-term goals. This concludes our prepared remarks. And now we will open the call for questions.

Operator, Operator

Our first question comes from Colin Langan with Wells Fargo.

Colin Langan, Analyst

Oh, great. Thanks for taking my questions. Just want to follow up on I think you made some comments on billings. They were down again year-over-year. I think at your Investor Day, you talked about kind of going from 380 to 480 in ‘23 to ‘24. How are you tracking now? I mean, is the ‘23 actually lower, cost of billings is coming in lower? And is there risk to 2024 sales targets if some of these launches get pushed out too much?

Tom Beaudoin, CFO

First of all, the metrics are related but distinct. The figures you mentioned pertain to embedded TTE use, and as we've indicated, we have experienced some production delays with the OEMs. We will present our guidance for 2024 in November. Regarding billings per car, which encompasses both embedded and connected technologies, it's influenced by those higher TTE uses that are experiencing delays. Additionally, this is a trailing 12-month metric. During certain supply chain shortages, some OEMs opted for higher-end cars, which incorporate more of our technology. As we've noted, our highest penetration is achieved by securing new opportunities in emerging markets where initial sales include one or two components. This results in a relatively lower billings per car but offers significant potential for accelerated growth with those OEMs as we add more components and features over time.

Colin Langan, Analyst

Got it. Thanks for the call. Just a second question. The other KPI that sort of stood out as the contract duration was 6.4 years, I think it was seven years. What is causing the average contract to shrink? What is driving them?

Tom Beaudoin, CFO

It's just a mix issue of deals and how those deals play out. I mean, it's still it depends on how OEM sign up for production schedules. It's still a quite a long commitment level for OEMs.

Operator, Operator

Our next question comes from the line of Luke Junk with Baird.

Luke Junk, Analyst

Good morning. Thanks for taking the questions. I wanted to start with a follow-up question on the billings per car metric again, really through the lens of what you're expecting from content per vehicle standpoint in fiscal 2024. And specifically, I'm just wondering to what extent the single component solutions that you've spoken to today were already contemplated in outlook or just how they impact the outlook for fiscal ‘24 in general. For starters, thank you.

Tom Beaudoin, CFO

Thanks, Luke, I really can't comment much on FY24, will provide our ‘24 guidance. And we'll take a look at the longer range plans when we do the Q4 guidance in November. But I think if you look across almost all the KPIs, it does show that we're continuing to win new business, we're continuing to get more active users, that connected and embedded are continuing to grow. The billings per car, I think, is just a factor of all the things that I mentioned. And it does provide some growth opportunities for us with some of these newer OEMs and some of these emerging countries. So I don't think it's a bad thing.

Luke Junk, Analyst

Got it. And then for my follow-up, maybe just a bigger picture question, a question of revenue models going forward. So the press release discussed the idea of positioning Cerence as an enabler for large language models and consumer tech in the car, sitting on top of the white label proposition that we all know. Just wondering to what extent you think you can get paid for that incrementally? And just any thoughts you can share on what that revenue model might look like? Are you conceiving of something that's more license-like that would be one-time? Or can we see more connected-like, sort of subscription models come out of this? Thank you.

Stefan Ortmanns, CEO

Maybe let me take this question and put volume, OEM. So, as we just said and what Tom mentioned, overall, we have a very high penetration rate. That's our foundation; we have a strong IP for conversational AI and a rock-solid business model, and also good relationships with OEMs. Now, how we can further improve the quality of our products? What you have seen also in the video, I think that's based on the integration of large language models and generative AI. We are working across the globe with all big OEMs on our new applications, for example, car knowledge, and we are prototyping with them. We are also in discussion on the business model, but I cannot go into the details here. But we have huge opportunities. Also the ChatGPT is quite expensive and Iqbal and the team are working on a very efficient, cost-efficient solution, also covering privacy topics. Maybe Iqbal, do you want to add a bit from your side on the technology here?

Iqbal Arshad, Chief Technology Officer

No, I think you've covered for the most part. Unless there's any other specific questions, I'll be more than happy to answer that.

Operator, Operator

Our next question comes from the line of Nicholas Doyle with Needham.

Nicholas Doyle, Analyst

Thank you for taking my questions. I wanted to know your thoughts on the two-wheeler contributions for next year. You mentioned total production around 50 to 60 million units and how you will account for differences in your longer-term projections. These differences are linked to transportation adjacencies. I'm curious about the size of these three models. Do they represent a significant portion of those units? Additionally, you referenced seven design wins in the first quarter. Are these three wins part of that pipeline? Thank you.

Tom Beaudoin, CFO

Yes, Stefan, let me hand it over to you. We've secured several design wins, with some moving into production in Q3 and more expected in Q4. The two-wheeler market is roughly half the size of the auto market, and this is a new area for us. We will need to observe how this develops. As mentioned earlier, it won't significantly contribute to FY23. However, as production ramps up and we receive royalty reports, particularly for these hybrid solutions, certain aspects will need to be amortized over the service life of the agreement. We'll provide further updates on this transportation adjacency market in November.

Stefan Ortmanns, CEO

And maybe let me also just add here that we have in total eight design wins, four went live into production in the last quarter. I think it's also distributed across the globe, in China, in India. There’s mass volume in Japan, North America, and also Europe. I expect that we will see also revenue growth in FY24 as Tom mentioned.

Nicholas Doyle, Analyst

Got it. And then for the emerging market wins, they're adopting one or two components. Is that related to the two-wheelers like side question? And can you just tell us more maybe what the one or two components are? What customers are really liking taking to and then how they're working with the software component and how much of that is related to the immersive companion?

Stefan Ortmanns, CEO

Overall, I think that was actually a contribution to this high penetration in the emerging markets here. That's cars in the mid to low range cost range. They're starting with typical audio AI, let's say for speech signal enhancement for enabling third-party opportunities like CarPlay, but that gives us the huge opportunity for bringing in our future solution for creating results, new OEMs, and also OEM branded AI solutions.

Operator, Operator

Our next question comes from the line of Daniel, I'm sorry, I can't pronounce your last name.

Unidentified Analyst, Analyst

Hey, this is Daniel on for Jeff, Craig-Hallum. Just on the connected units, really strong performance, I see it up 50% year-over-year, the number of units. Just wondering, would you view that sort of as lumpy numbers or indicative really of a larger trend there in terms of the strength of connected? And in terms of if that is more of a larger trend, more success than we've been seeing in a while? Do you view that as a change in buyer behavior? Is that the product sort of reaching a critical mass on the capabilities? How would you see that momentum?

Stefan Ortmanns, CEO

So let me start for us, and then I will hand it over to Tom. Overall, we reported over the last three, four quarters, a couple of design wins and wins back also on connected services. This is our foundation. Also across the globe, I think we have clearly improved the quality for connected services. We are in discussion for more because we have, as I said, also in the last call, this order opportunities. We're driving quite a lot of new innovation, especially on the connected side. Clearly, this is our advantage also in various benchmarks across the globe. Tom?

Tom Beaudoin, CFO

Yes, I mean, as we said, I mean connected is a great opportunity for us because it sits on top of our embedded and it provides some of the key elements of our destination next and immersive cabin. You do have to adjust a little bit from the previous quarter where we had a $700,000 true-up from a customer that under-reported, but even when you adjust to that, you're right, we're starting to see growth there. As Stefan said, some of these programs are going live. We've also talked about over the last few quarters that there were some older contracts that were coming to the end of their amortization schedule, and they weren't up for renewals. They are just older programs separate from the legacy one that we split out separate. For the most part, we probably replaced newer technologies on newer platforms going forward. So, we're pretty excited about the connected opportunities, and a lot of it plays to what Iqbal was talking about around the enhancements there that are being made to the products.

Unidentified Analyst, Analyst

Thanks for that. I have a follow-up regarding the press release from July about your partnership on IoT use cases. Can you clarify the nature of the agreement and the flexibility to explore related areas? Is this primarily about technology development, or does it include opportunities to engage with customers, and where do we stand on the timeline for this?

Stefan Ortmanns, CEO

Also here, I think, no, we have a restriction here. The field of use restriction was resolved with Microsoft, and this FOU expires in a year from now, October ‘24. As you can imagine, we are already planning the areas where we can go in. There was also recently a press release from us that we have also optimized the embedded AI stack for new devices. We see huge potential for us also in the future beyond ‘24.

Tom Beaudoin, CFO

In the short term, there are two or three technologies that were developed and owned by Cerence that we can play. Some of it's in our audio stack. Some of it’s in our text-to-speech. We also have developed our own voice biometrics technology, separate from what came over at the time of the spin. There are opportunities that we're pursuing in those particular areas that are exempt from the FOU for the next year. And then as Stefan said, pretty much a year from now there are no restrictions.

Stefan Ortmanns, CEO

Yes, and we have also established a team fully dedicated to non-transportation opportunities for us, business development and R&D people.

Operator, Operator

Thank you. I am showing no further questions at this time. I would now like to turn the conference back to Rich for closing remarks.

Rich Yerganian, Senior Vice President of Investor Relations

Thank you, Brittany. And thank you everyone for joining us on the call this morning. We look forward to having further discussions. Enjoy the rest of the summer. Thank you.

Operator, Operator

Great. Thank you so much. This concludes today's conference call. Thank you for participating. You may now disconnect.